☕ New Michael Mauboussin paper on Drawdowns and Recoveries
Saturday: Weekend Reads — New paper on drawdowns and recoveries
Michael Mauboussin published a new paper on drawdowns and recoveries. Check it out:
My favorite quote:
Wes Gray is the chief executive officer of Alpha Architect, an asset management firm, and has a PhD in finance from the University of Chicago. He wrote a great piece called, “Even God Would Get Fired as an Active Investor.”7 His point is that if you had the (godlike) foresight to build a portfolio of the stocks that would produce the highest TSRs over the next five years, you would have “great returns, but gut-wrenching drawdowns.” In other words, the drawdowns are so large that a client who hired you to be their active manager might fire you.
Gray built his thought experiment on data for the components of the S&P 500, an index of about 500 of the largest stocks in the U.S., or an equivalent precursor index, from 1927 to 2016. The first portfolio was constructed on January 1, 1927, rebalanced every 5 years, and weighted by market capitalization. Over the full period, the perfect-foresight portfolio of the top 50 stocks produced annualized returns three times those of the S&P 500.
The worst drawdown for the perfect-foresight portfolio was 76 percent (August 1929 to May 1932), and there were 5 drawdowns of 30 percent or more. Even the perfect portfolio tests the resolve of those who own it.
My second favorite quote is from Munger, aptly describing reactions to downturns:
“I think it's in the nature of long-term shareholding with the normal vicissitudes in worldly outcomes and in markets that the long-term holder has his quoted value of his stock go down by say 50 percent. In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50 percent 2 or 3 times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you are going to get—compared to the people who do have the temperament who can be more philosophical about these market fluctuations.”1
I’ve said it before and I’ll say it again: when Mauboussin publishes something, you should read it. Take the time today to absorb it.