Even God has to Live with Stock Market Volatility

By Amit Rupani

Few months back I came across a very profound study by Wesley Gray, PhD founder of Alpha Architect, an asset management firm. Gray's study looks into performance of portfolios with perfect foresight as compared to S&P 500. He calls this portfolio with perfect foresight as “God's Portfolio." He was curious to find if god is omnipotent, could he create a long-term active investment strategy portfolio that was so good that he could never get fired? Let's look into how he structured his test and its remarkable findings.

The Design of Gray's “God" Study #1

Study computed 5-year “look ahead" return for all common stocks for the 500 largest NYSE/NASDAQ/AMEX firms starting on 1/1/1927 till 12/31/2016. God's portfolio is constructed on 1/1/1927 with 500 stocks which had best five year returns and was held passively for five years until 12/31/1931. The second portfolio would be formed on 1/1/1932 with 500 top performing stocks and held until 12/31/1936. This pattern repeats at the end of every fifth year. We would have had 18 of such “God's Portfolios" between 1927 and 2016. Now it's time to look at the findings.

As expected, God's best portfolio has outperformed S&P500 by big margin given god had perfect foresight. But the interesting part is that the God's portfolio had higher standard deviation than S&P500. Standard deviation is also a measure of volatility in the stock market and the study results shows us that even with perfect foresight; God's portfolio had to live through higher volatility compared to S&P500.

The Design of Gray's “God" Study #2

For the second study Gray created “God's Hedge Fund Portfolio." He leveraged God's perfect foresight and went long (buy) the known winners and short sell the known losers. Why not make money on both sides? Same portfolio construction pattern – buy five year winners and short sell five year losers which are rebalanced every month. Let's look at the findings.

Again as expected, god's best long-short portfolio beats benchmark by very big margin. God's portfolio returned 46.23 percent annual return. But still its standard deviation (volatility) was higher than the market. Even with perfect foresight on both long and short side, it wasn't able to decrease the volatility. When we look at the 1-year relative annual return over time between God's Hedge Fund Portfolio and the S&P500 – there were multiple occasions when God's hedge fund was beaten by S&P500 by 50 percentage points – or more! So not only this portfolio with perfect foresight on both long and short sight was more volatile than S&P500, but had underperformed the market on multiple occasions. Not many money managers in today's era would have their job, if they underperform benchmark by 50 percentage points.

An electrocardiogram (ECG) is a medical test that measures the electrical activity of the heartbeat. A normal ECG pattern looks like below picture:

It closely resembles with a stock chart of any normal stock traded in the market. It goes up, goes down, bounces from low, falls from peak, but never moves in a straight horizontal line. A straight horizontal line in an ECG would mean that a person's heart has stopped beating and is dead. Similarly, the stock market would die if there is no volatility. Volatility is the heartbeat of the stock market and we have to live with it. It's just how this beast works.

Gray's study also confirms that even God's portfolio with perfect foresight can't beat the market when compared to its volatility.

Buying right and sitting tight through the volatility is the no brainer concept to tackle stock market volatility.

Wesley's Gray's article with his study findings can be accessed through alphaarchitect.com/2016/02/02/even-god-would-get-fired-as-an-active-investor/

Happy Investing!

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Amit Rupani, CFA is an Independent Investor, practices Value Investing principles, manages money for long-term wealth creation through Equities asset class. Email: rupaniamit@yahoo.com