It’s been a month, yet it’s still hard to believe. The Toronto Raptors are NBA champions! Before this season started the team had been consistently good, but not great. Sure, they had won their division in four of the previous five seasons, but they had also only won a combined four playoff series in that time. It was clear to anyone who was paying attention that the roster as assembled for the 2018 season just wouldn’t be good enough to win it all.
Raptors team president Masai Ujiri was certainly paying attention. In July 2018 he gambled in a big way, going all-in on a championship run for the 2018-2019 season. He traded away fan favourite DeMar DeRozan and the three years left on his contract to the San Antonio Spurs for Kawhi Leonard – who only had one year left on his contract.
We now know that, yes, Kawhi did deliver the championship to Toronto that DeMar had failed to. But Kawhi also subsequently declined to re-sign a new contract with the Raptors and will instead be playing for the L.A. Clippers next year. So it’s been a bittersweet month for Raptors fans.
But how bitter and how sweet has this experience been for Raptors fans? Which situation would they rather now find themselves in: (1) the actual one, with a championship title, but a team that likely will be re-building over the next few seasons, or (2) no 2018 Kawhi trade and no championship, but a team that will remain fairly competitive over the next two seasons with DeMar DeRozan?
Sports being what it is, Raptors fans are undoubtedly going to take situation (1), the championship. Winning and losing in sports is a zero-sum game and banners hang forever. Furthermore, from the team’s perspective, winning a championship can increase the number of lifelong fans they collect.
But what about investing? Like sports, does it pay to go all-in?
There are no investing championships
From our point of view, we say “no”. We would rather manage a portfolio that generates consistently-respectable returns year-after-year instead of one year of big returns followed by multiple years of losses. In other words, we would rather have a portfolio that locked-up DeMar DeRozan for many years, instead of a portfolio that benefited from Kawhi Leonard for just one year.
The reason? Losing in investing is much more painful than losing in sports. In sports, if you have a bad season you still get to start the next season from scratch. Losses don’t carry over from one year to the next.
On the other hand, investing losses can carry over for many years. For an example we provide the following chart. It shows the value of two hypothetical portfolios, both of which start with the same value. The portfolio represented by the blue line churns out steady 10% annual gains year after year. The portfolio represented by the black dashed line, however, generates an unfortunate 50% loss in year one followed by an impressive 20% gain each year afterwards. Even though the latter portfolio eventually generates returns that are double the former, it is not until after year ten that they are again equal in value. That’s a long time to spend making up for losses.
If you think that an example as simple as this one would make it clear to all investors that – first and foremost – losses should be avoided, well, you would be wrong. Part of this is human nature: people are more likely to boast about making a profitable investment than to boast about avoiding a losing investment. But part of this also comes down to marketing.
Which of the two mutual funds do you think someone would be more likely to invest in? Fund A that generated a 25% return last year or Fund B that generated a 5% return last year? Both you and the clever people who work in mutual funds’ marketing departments know the answer is likely Fund A. Even though marketing material likely includes the disclaimer that “Past performance is no guarantee of future results”, this line is probably going to be relegated to the fine print.
Run a fund like a sports team
But wait! What if there was some way for a mutual fund to start fresh, just like a sports team does every season? Well it just so happens there is. As this CNBC article puts it:
Imagine you sent 100 bombers on a mission. Fifty crashed, and 50 dropped their payloads and returned. What if you looked at the 50 that returned, called the mission successful and then wrote a report that never mentioned the 50 lost planes?
In other words, when evaluating mutual funds, investors needs to be aware of survivorship bias. Mutual funds that have a history of underperformance are frequently closed or merged with other, better-performing funds. This study found that for the five-year period ending in 2011, 62% of large-cap value mutual funds outperformed their benchmark. Buuuuuuuuuuuuuuut, this 62% figure does not account for funds that were closed during that period. If these closed funds were included in the analysis, only 46% would have outperformed their benchmark.
We suspect this is one of the reasons why mutual fund companies offer such a large number of different funds to their clients. If one fund underperforms, clients can easily be switched into another fund that has – historically – outperformed. Eventually, many of the underperforming funds will then be closed such that the fund company is left advertising only new funds and funds that have outperformed historically.
Thus, for some mutual fund managers, this leads to an incentive to go all-in on a fund’s short-term investment results while paying less attention to the longer-term downside risks. If the fund knocks it out of the park, great! Promotions all around! If the fund falters, no worries! The company can just close it and start fresh with a new one.
We don’t manage our investments one season at a time
We manage two funds: one equity fund and one fixed-income fund. The performance of those funds reflects our decisions to protect against downside risk while generating respectable upside consistently. We don’t go all-in on one year’s performance, knowing that we could just erase any mistakes from the record. It may more boring than populating the portfolio with the latest high-flying assets, but we believe that this approach will prove to be the most profitable one over the long-term. With all due respect to Kawhi, we believe that the Bored Man Gets Paid.