Capital Preservation Paul, Part III

Last week we asked Mr. Market to establish the playing field for our investment contest. This week we’ll check in to see how our contestants are faring.

Year 1 of the contest, we will recall, was a so-so, boring year in the markets. Mr. Market’s portfolio—that is, a portfolio with exactly the same asset allocation strategy as that of the contestants, but invested entirely in index or index-like investment products—rose from $100,000 to $104,000.

Notice that we’re judging our contest by looking mainly at dollars, not percentage returns. You can’t eat return, of course; all you can eat is the resulting dollars. And returns can be deceptive, as I pointed out in a post earlier this year. Because of the phenomenon of variance drain, it’s possible to achieve a high return and still end up with fewer dollars.

Consider a $100 portfolio that rises 4% in year 1 and declines 4% in Year 2. It’s not quite worth $100, but it’s pretty close: $99.84. But a $100 portfolio that rises 50% in Year 1 and declines 50% in Year 2 is worth only $75. Volatility matters, and if we overlook that small fact we might imagine that a portfolio that returns 10% per year over an investment lifetime will naturally produce greater wealth than portfolios that return 9% or 8% per year. Au contraire, mes amies.  If the lower-returning portfolios also experience much lower volatility (variance), they can produce considerably more wealth than the higher-returning portfolio.

Some of our competitors—Lauren Buffett and Capital Preservation Paul—are well aware of this phenomenon and, over longer periods of time, that will give them a considerable advantage over Patient Patty and Typical Tom. However, over the short, five-year period of our contest, variance drain won’t be a factor, so we have a level playing field.

But back to the competition:

Lauren Buffett, not surprisingly, did pretty well in Year 1. She’s a terrific investor, and thus even in a so-so market her so-so return was better than most people’s so-so returns. Lauren’s picks for managers and other investment products are just slightly better than most people’s, and she ends the year with $105,000. Obviously, that’s not a big delta over what an indexed portfolio produced, but remember that investing is a game of inches. If, over a 50-year lifetime, Lauren can keep getting 5% while indexed portfolios keep getting 4%, she would create nearly twice as much wealth: roughly $1,200,000 versus about $740,000, and that’s without factoring in Lauren’s lower volatility. When Albert Einstein remarked that compound interest was the most powerful force in the universe, he wasn’t just whistling Dixie.

Patient Patty did “just okay.” Since she never looks at her portfolio she doesn’t realize what a bunch of clunkers she has in there. On the other hand, she also owns some good stuff, though she doesn’t know that, either. Patty finishes the year at $103,500, but she doesn’t know whether to be happy or sad about that result since she doesn’t know she achieved it. As we noted last week, Patty never looks at her portfolio for a perfectly sensible reason: she knows she is really a Typical Tom in disguise. In other words, if she obsessed about her portfolio and about the markets, she would almost certainly make all the same behavioral mistakes other investors make. So she pays no attention at all. It sounds crazy, but it prevents Patty from morphing into Tom, which is exactly what Patty is hoping to avoid.

Typical Tom stunk the place up in year 1, finishing the year with only $102,000. The main problem for Tom is that he’s still smarting from the last Bear Market, several years ago (before our contest started but not before investors began making mistakes). Tom’s strategic asset allocation targets are the same as everyone else’s, but Tom isn’t at his targets. Having been badly burned in the last Bear Market, Tom dumped his stocks and, even today, still has way too much capital rotting away in cash and bonds. Year 1 wasn’t a terrific year for equities, but they still beat bonds and cash, and so Tom got left behind.

Capital Preservation Paul, for whom your humble blogger maintains a quixotic fondness, had a so-so year, although his so-so year wasn’t as good as Lauren’s so-so year. Paul was pretty much fully invested at his strategic targets, as he usually is, but Paul selected managers and investment products that were on the safe side. Value tilts, low P/Es, and managers holding cash proliferate in Paul’s portfolio. Why? Because he’s capital preservation-oriented, of course. If he’d known that the markets would be up, in aggregate, 4%, he’d have invested more aggressively. But since he didn’t—indeed, since he couldn’t know—he tilted his portfolio toward safety. This, of course, is a congenital problem for Paul, for whom the Pappy Van Winkle shot glass of market valuations is always half empty. Market valuations actually weren’t high as we entered our contest, but they weren’t terribly low, either. Paul, as he will always do, decided to err on the side of caution. He ended the year at $103,000.

So at the end of Year 1, with the indexed portfolio standing at $104,000, here are the standings:
Lauren..…………………………………. $105,000
Patty…………………………………….. $103,500
Paul……………………………………… $103,000
Tom……………………………………… $102,000

Next week, we’ll check in again and see how our competitors fared in very different market environments.

Next up: Capital Preservation Paul, Part IV