As my colleague, Brad Jung, has emphasized in his popular blog series about the value of an advisor
, an advisor’s single largest contribution to their clients’ investment return is when the advisor helps prevent poor behavior. Depending on the market environment, that “poor behavior” typically manifests itself as decisions to sell at the bottom or buy at the top.
Turning reality on its head… to make a point
One way to help clients understand the benefit of resisting those counterproductive instincts is to turn reality on its head:
Ask your clients to imagine, for the sake of argument, that they could invest in a portfolio that contains only those stocks that will wind up being the top performers after a certain period of time.
What would that investment experience be like? Would knowing that this is the “sure bet portfolio” make it easier to avoid flinching when market volatility strikes, when one of the portfolio holdings goes through a rough patch, or when another company not included in the “perfect” portfolio begins to rally strongly?
Example: the perfect portfolio
Let’s look at an example: Let’s say that a decade ago, we knew which 10 U.S. companies would be the top returners today and your client invested in only those 10 stocks. Based on the companies in the Russell 1000® Index today, the 10 top performing stocks over the past decade as of April 30, 2016 were:
This is not a recommendation to purchase or sell these – or any other specific – individual securities.
This hypothetical portfolio’s 10-year return as of April 30, 2016 was 2144% cumulatively, or 35% per year on average. Not too shabby, especially compared to the 7% annualized average return of the Russell 1000® Index for the same time period.
Pre-requisite: conviction, trust and nerves of steel
But what kind of behavior does this sort of track record require? Conviction, trust and nerves of steel.
For one thing, investing in just 10 stocks, and these 10 in particular, on April 30, 2006 would have required conviction and confidence. At that time,
- Medivation’s common stock had only just been approved for listing on the stock market. The company didn’t yet have a single product on the market yet. Its Alzheimer’s drug would fail in late-stage clinical tests in 2010 and its blockbuster prostate cancer drug wouldn’t gain FDA approval for another six years.
- Netflix was known as a DVD-rental-by-mail company competing for customers with Blockbuster. It wasn’t clear at the time which company would win out.
- Apple’s iPhone wouldn’t exist for another year.
From April 30, 2006 to April 30, 2016, this hypothetical portfolio experienced swings of nearly 50% in value. So, even this “sure bet” portfolio would have been the source of a fair number of sleepless nights and challenging for many investors to survive. No wonder, then, that many investors have a hard time sticking with their portfolios that don’t have the benefit of foresight.
Diversification potentially to the rescue
That’s precisely why portfolio diversification – although it doesn’t protect against a loss or guarantee a profit – can help investors stay the course when the going gets rough. When diversification is at its best, there will also be parts of the portfolio that are excelling while others may be lagging.
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The bottom line
In real-life investing, there’s no way to know with absolute certainty which investment opportunities will be rewarding and which ones will be disappointing. But helping clients appreciate that even a hypothetical portfolio with perfect hindsight would experience its fair share of wild swings, may help keep them practice good behavior when their “real-life portfolio” plants seeds of doubt in their mind.