In Search of the Perfect Portfolio

“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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  1. Monday links: imperfect portfolios | Abnormal Returns commented on Jul 07

    […] Ben Carlson, “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.”  (A Wealth of Common Sense) […]

  2. My Own Advisor commented on Jul 07

    Absolutely:

    “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.”

    For me, that’s investing in established CDN and US stocks that pay dividends and coupling those picks with a couple equity ETFs. Then, buy when the market corrects or crashes. Rinse and repeat.

    Mark

    • Ben commented on Jul 08

      Yup, knowing what you will or won’t invest in gets you about 90% of the way there. As long as you behave your probability for success only increases.

  3. Robb Engen commented on Jul 08

    I see a lot of young investors who appear to embrace the passive investing strategy but get caught up looking for the perfect portfolio. They obsess over whether to add certain sectors, like missing 5% precious metals is going to haunt them two decades down the road. They obsess over fees, quick to change funds over hundredths of a percent. The constant tinkering can only lead to trouble, trying to overweight asset classes or time their jump in-and-out of funds, and the continuous churning of funds.

    Just leave it alone and focus on what really matters – saving more.

    • Ben commented on Jul 08

      Great points. Figure out a portfolio plan and behave. Unfortunately easier said than done. I’m a huge proponent of the 80/20 rule that says 80% of your output comes from 20% of your inputs. Asset allocation gets you 80% of the way there. The rest is tinkering and as you said mostly leads to issues.

      You had a nice post on Boomer & Echo on this recently that I enjoyed.

      • Robb Engen commented on Jul 08

        Thanks Ben! I’m a new(ish) reader here and really enjoying your stuff.

  4. Leah commented on Jul 09

    Good post proving that, for most people, automating the behaviors gives the best chance at success. And, instead of buying the dips or sell offs, they need to just automatically DCA with their automated savings!
    Assuming they have a properly designed investment plan –
    Almost any diversified portfolio that isn’t thwarted by emotionally driven changes will improve investors’ returns getting them closer to the markets’ returns.
    But, the transaction fee earning system won’t like that as much so, it seems like every investor ends up having to figure this out and implement it herself!
    Keep up the good work – AWCS is at the top of my reading list.
    Leah

    • Ben commented on Jul 09

      Thanks for reading. I agree with you…behavior is the most important factor for investment success (no matter what the strategy is). Automating good behavior is one of my favorite pieces of advice, especially for newer investors who don’t have as much experience with the markets.

  5. Brian So commented on Jul 11

    The problem is people making the mistake of chasing past returns. They see their friends and family make double digit returns and they want to get in on the fun. The problem is even if they’ve seen an asset allocation quilt, they’re unable to overlook recent returns and overcome their overconfidence (sorry for all the overs :p). It results in them getting burned by the market time after time.