A tale of two investors, same investment, different results!
In our hypothetical scenario each one of two investors, Joe and Blogs, invested on 31st December 2000 in a fund trading the SG CTA Index. Joe was the Chief Investment Officer of a major Pension Fund with very long-term liabilities. Joe’s bonus and pay package was a function of his long-term results. Joe bought the investment and held it until 31st December 2015 without touching it.
Blogs was a prop trader at a major investment back (Let’s assume Dodd-Frank did not pass!). His bonus and pay package was a function of the prior year’s quarterly profits. Blogs tried to be a bit more clever. He noticed that like every investment, the SG CTA Index had its up and down periods. So he tried to outsmart the fund and time his entry and exit from it. He devised a formula under which Blogs would sell his investment if the performance of the fund over the trailing twelve months turned negative. He would repurchase his investment as soon as the performance of the trailing twelve months turned positive again. This way, he though, he would limit his losses to only the losses of the first twelve months, while at the same time making the most of the profitable periods as soon as they resumed. His rationale seemed very reasonable and one would think Blogs would perform better than Joe, having applied some additional risk management tools!
Between December 2000 and 2015, the Fund delivered a handsome +104.93%. Joe made 104.93%, the whole of the Fund’s performance, since he bought and held his investment until the end of the period without any interference. Blogs on the other hand, surprisingly made only 61.39%. One would expect Blogs to perform better having applied some really smart risk management. Exhibit A below shows the performance curve of the two investors.
Even if Blogs used a different look-back period to decide when to enter and exit the Fund, his performance would still lag that of Joe. So how is this possible? Why would the addition of a rational risk management tool by Blogs to time his entries and exits objectively result in lower performance. Let’s examine in detail a sample period to see at which point Blogs underperformance starts to develop to understand what is the reason behind it.
Exhibit B shows a sample period when the cumulative performance of the two investors started to diverge.
|Date||Fund monthly performance||Joe Invested||Joe cumulative performance||Fund trailing 12month returns||Blogs invested||Blogs cumulative performance|
Until February 2002, both investors were continuously invested in the Fund since December 2000. So they had the same cumulative performance as of that date, -0.20%. However at the end of February 2002, the Fund’s trailing 12 month performance turned negative at -1.07%. So Blogs decided to sell his investment at the end of February, to limit his losses to -0.20%. Until April 2002, this proved to be a good strategy since Joe had accumulated losses amounting to -1.64% whereas Blogs losses were limited to a mild -0.20% when he sold his investment back in February.
However in May and June the Fund performed very well. Joe profited from this strong performance whereas Blogs lagged behind because he was out of the Fund. Although the Fund was doing well, the trailing 12 months performance was still negative in May and only turned positive at the end of June. Blogs invested again in the Fund at the end of June when trailing 12 months’ performance turned positive. However, it was too late. He already missed the upside of May and June amounting to a respectable 11.2%. So from this point on, Blogs performance lagged Joe’s by at least 11.2%. The divergence increased further when Blogs additional attempts to time his entries and exits resulted in additional lags. By December 2015, Blogs lagged Joe’s performance by 43.54%!.
What is the takeaway of this example? The future is unknowable and therefore it cannot be forecasted, or timed in any consistently reliable way. We as humans have the tendency to lean on psychologically easy investment decisions. Faced with a losing period, Blogs did the obvious and sold his investment. Then when the Fund started doing well again he did the obvious and bought his investment back. Although this strategy makes us feel better, in the long-term it is the wrong one as shown in the above example. Contrary to Blogs, Joe proved more resilient. He held onto the loosing periods as much as he did during the winning ones. Rest assured this was not easy. It is draining for an investment professional to see his investment lose value and not react. Yet, provided the investment thesis remains sound, this is the right approach and in the long term it will pay off.
When we evaluate an investment to be a good proposition for the risk we are taking, we invest in it and provided our original thesis has not reversed we do not sell it merely on temporary blips in performance. Although this is easier said than done, over the long haul it is the right approach and our reward will be the maximum that will be made available by the said investment.