Never wish to show courage, a wise man once counseled; courage can be displayed only in circumstances where one’s natural instinct is to be afraid, and fear is an unpleasant emotion. This principle, with obvious qualifications, applies to investment management. Successful portfolio management can require holding positions when one’s natural instinct is to sell.
ONCE UPON A TIME
It is Dec. 31, 1999. You are a professional portfolio manager pondering long-term stock selections for your clients. You share Warren Buffet’s view that “Our favorite holding period is forever,” and you decide to ask each of your four favorite Wall Street forecasters to recommend a stock to hold indefinitely. They obligingly recommend four different names, denoted for now as Stocks A through D, which you carefully consider.
You’re well aware that some recommendations work out better than others. What might cause you to lose confidence in any of these four stocks? Since you will be buying the stocks in the expectation that they will go up, and in fact will outperform the market, a period of disappointing returns might weaken your determination to hold forever.
While contemplating all this, you have been holding a very old bottle of wine that a friend gave you for your last birthday. You open the bottle, thinking that a taste might help resolve your perplexity. As you remove the cork, suddenly vapor spews out and a genie emerges. In gratitude for your having released him, he offers you a wish.
Of course, what you wish is to know which of the four stocks will be the best performer for the next 20 years. Unfortunately, our genie has been corked up with the wine for a bit too long. He knows a good bit about volatility but very little about the returns of individual stocks. The genie does know that the market will go up in the next 20 years, and that individual stock returns will be highly skewed, as Exhibit 1 illustrates. The median stock in the S&P 500® will appreciate by 52%, well below the average appreciation of 239%. Only 267 of the 1,010 stocks that will appear in the S&P 500 for the next 20 years will beat the average.
Having been made aware that a relatively small number of stocks will determine your success or failure, you’re happy to have whatever specific information you can get, and ask the genie to tell you what he knows about the four recommendations.