The Optimal Path for Investors to Achieve Long-Term Outperformance
Financial analyst Noah Solomon addresses a critical question for investors: For any given level of risk tolerance, what is the optimal path to achieving higher returns? This inquiry lies at the heart of portfolio management and long-term financial success.
Understanding the Risk-Return Relationship
It is widely acknowledged that individuals with a lower tolerance for risk must accept lower returns compared to those who can bear greater risk. Conversely, investors willing to embrace more risk can anticipate higher returns than their conservative counterparts. However, this fundamental principle does not alter the fact that any rational investor, regardless of their risk appetite, would prefer higher returns for the risk they undertake. Similarly, they would favor lower volatility when targeting a specific rate of return.
The Double-Edged Sword of Aggressive Outperformance
Striving for performance that significantly exceeds the norm constitutes a double-edged sword. While it can yield planned successes, it also exposes investors to the risk of substantial underperformance. The long-term effects of oscillating between strong outperformance and strong underperformance are illustrated through historical data.
For instance, consider monthly returns for the TSX Dividend Aristocrats Index ETF, used as a benchmark for dividend-focused Canadian equity funds since 2008. Compare this with an Alternator Fund that switches every 12 months between underperforming the index by five percent and outperforming it by five percent. A symmetrical combination of well-above and below-average returns results in a long-term record characterized by slightly lower returns, higher volatility, and larger losses during challenging market conditions.
The key takeaway is that managers who aim to consistently outperform by a substantial margin each year are highly likely to deliver subpar results over the long term.
Slow and Steady Wins the Race
Legendary investor Howard Marks once recalled a discussion with the director of a major Midwest pension plan. Over 14 years, the plan's annual returns never placed below the 47th percentile or above the 27th percentile relative to peers. Despite this seemingly uninspiring performance, its portfolio ranked in the fourth percentile over the entire period.
This example underscores a vital lesson: if you swing for the fences and attempt to be in the top five or ten percent every year, you fall victim to the double-edged sword, delivering long-term returns that are, at best, mediocre and accompanied by high volatility.
In contrast, delivering performance that is slightly above average on a realistically consistent basis, with particular emphasis on outperforming in bear markets, leads to substantially better long-term outperformance. This approach also subjects investors to lower volatility and shallower losses during challenging market environments.
By focusing on moderate, consistent gains rather than aggressive swings, investors can navigate the complexities of financial markets more effectively, aligning their strategies with sustainable growth and risk management.
