In Search of the Perfect Portfolio

by Ben Carlson, A Wealth of Common Sense

“There is no such thing as a perfect portfolio. We’ll only know what was perfect in retrospect. There is, however, a portfolio strategy that will meet your needs. It’s conceived from your financial situation, your understanding of risk, your time horizon and your desires.” – Rick Ferri

MarketWatch columnist Brett Arends has been looking for the Holy Grail of investment portfolios. In a recent article he describes his search for a simple ‘perfect portfolio.’

In the end he came up with a broadly diversified global portfolio consisting of 10 equal-weighted asset classes that are rebalanced on an annual basis.

I appreciate the fact that Arends is looking for a simple, diversified portfolio that, as he says, “maximizes my chances of earning a good long-term return, and minimizes my chance of ending up in the poor house.”

I’m just not so sure that his choice of words makes sense for investors. There is no such thing as a perfect, all-weather portfolio. It doesn’t exist. There is only a most-of-the-time-this-works-portfolio because nothing works all the time in every environment.

Craig Israelsen wrote an article for Financial Planning Magazine where he analyzed a portfolio made up of 12 different asset classes. He first looked at the what would happen if an investor had perfect foresight to choose the best performing asset class in advance each year:

Assuming a person could accurately pick each year’s winning asset class at the start of each year, and devote an entire portfolio to that asset class, that investor’s 15-year annualized return would have been an astounding 32.25%, with a standard deviation of annual returns of just under 19%.

Obviously, that would be impossible since no one can predict the future and there is no rhyme or reason to annual asset class performance.  Look at any asset allocation quilt to understand this dynamic.

While the perfect portfolio is impossible, investors can easily invest in a terrible portfolio.  Israelsen next looked at what would have happened if an investor based their purchases strictly on past performance by investing in the top performing asset class from the prior year:

The “perfect” 32.25% annualized 15-year return plunged to 2.71% for an investor using this strategy during the 15-year period, while the standard deviation of annual returns increased to 23.7%.

In fact many investors fall for this trap by investing in the hottest performing sector or asset class.  It’s why fund flow data shows that investors pile into asset classes after large gains and pull money out after large losses, the opposite of a prudent investment strategy.

This is the problem with a search for perfection.  There are only perfect past portfolios, not perfect future portfolios.  You could go through all of the asset allocation studies, Monte Carlo simulations or risk tolerance questionnaires you can find but all they will tell you is how certain portfolios have performed in the past.

While these tools can be useful as a way to gauge possible risk factors, assuming future cycles will play out exactly as they did in the past can lead to overreactions when things don’t go as planned.

If your goal is to create a perfect portfolio you have basically already lost because you are only setting yourself up for disappointment.  It’s a pipe dream. There are only investment styles that fit your personality and allow you to meet your needs with a high probability for success.

The real “perfect” portfolio is whatever approach allows you to stick with your investment plan without completely abandoning your strategy at the worst possible times.

It’s the portfolio that helps you eliminate any possible behavior gap that comes from chasing hot funds, buying high or selling low and investing in products or markets that you don’t understand.

Sources:
Building the ‘Perfect Portfolio’ (Financial Planning)
Is this the Perfect Investment Portfolio? (MarketWatch)

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