Optimization Versus Maximization

“Never forget the 6-foot-tall man who drowned crossing the stream that was 5 feet deep on average” – Howard Marks

A quick market update:

?For those who fell asleep on July 16th and awoke on August 29th , the S&P 500 would have hardly shown a change, ?down a little more than 1%. For those of us not fortunate enough to have enjoyed six weeks of sound slumber, we know capital markets have experienced a more eventful path towards an otherwise flat return. From July 16th to August 5th , the S&P 500 fell 8.5%, just 1.5% shy of a technical correction (-10%) which the tech-heavy NASDAQ did experience, having fallen 13% over a similar time frame. Since the first week of August, both the S&P 500 and NASDAQ have gained around 8%, leading the S&P 500 to a nearly full recovery. These periodic bouts of volatility, particularly where a sharp selloff is followed by a quick recovery, are great reminders for long-term investors to avoid impulsive, emotional decisions. An investor in the S&P 500 index who might have abandoned their strategy on August 5th would have not only solidified the drawdown in their portfolio, but more importantly missed the 8% gain that followed. Unfortunately, this inopportune timing is what causes many investors to realize inferior investment returns relative to a benchmark, potentially leading to an abandoned investment strategy and ultimately unachieved financial goals. ?

Howard Marks, legendary investor and founder of Oaktree Capital, is known for his wisdom as much as he is for his investment acumen. In expanding on his quote used at the beginning of this commentary, Marks goes on to say that “the important thing to remember about investing is that it is not sufficient to set up a portfolio (or strategy) that will survive on average. The key is to survive at the low ends.” In other words, being able to endure volatility, especially deep or extended periods of volatility, is critical for long-term investment success. While this sounds simple, and it very much is, human emotion (including fear and greed) often causes investors to compromise prudent risk management in an attempt to maximize returns. But maximizing potential upside does not exist without amplifying potential downside – this is the basic symmetrical concept of risk and reward.

Have you ever heard of the famous investor Rick Guerin? Probably not, and you’re not alone. In the 1960s three prominent value investors made many investment decisions together, including Blue Chip Stamps and See’s Candy. Their names: Warren Buffett, Charlie Munger and Rick Guerin. Two of these are famous household names for those who have read anything about investing. But Rick Guerin is virtually unheard of. Why? Mostly because he was focused on maximizing returns above all else. Guerin’s investment style diverged from Warren and Charlie’s into the 1970s, Buffett recalls, as he ?began using leverage (margin) in an attempt to maximize his fund’s investment returns, which worked until it didn’t. Guerin’s performance record was ruined during the 1973-74 downturn due to this use of margin, effectively derailing his investment career, at least to the magnitude of Buffett and Munger’s. As Warren Buffett eloquently remarked in a later interview, “Rick was every bit as smart as Charlie and I, he was just in a hurry.”

Current data also supports this idea. A recently-published research report (Why Investors Missed Out on 15% of Total Fund Returns | Morningstar) by Morningstar analyzed the investment performance of fund investors over a 10-year period ending December 31, 2023, using more than 20,000 fund share classes that accounted for over $12 trillion of net assets at the beginning of the decade. The findings were interesting, although perhaps not surprising:

• Fund investor returns averaged 6.3% per year (dollar-weighted) over the 10-year period while the fund returns averaged 7.3% per year on a total return basis. In other words, the underlying investment performed 1.1% better per year than the investors who owned the fund.
• This 1.1% return shortfall is attributable to ill-timed buys and sales by the investor of the underlying investment.
• Index mutual funds experienced a gap of 0.2% per year while index ETFs produced a 1.1% gap. ETFs (exchange-traded funds) are tradeable intraday, versus once per day for mutual funds, allowing more opportunities for mistimed buys and sales.
• Volatility was the single largest contributor to higher gaps between investment and investor returns. The more volatile a fund’s return versus peers, the larger the gaps tended to be.

What does all this mean and what can be done about it? First, the data helps validate that behavioral biases not only exist in investing, but can also be a hindrance to long-term investment returns. Morningstar’s research illustrates that volatility is the most prevalent cause of larger investor/investment return gaps, as funds with higher volatility led owners to make more ill-timed buy and sale decisions. Investors can relate to the words of modern philosopher Taylor Swift when she says "it's me, hi, I'm the problem, it's me." We also know that investors commonly seek to maximize returns, which often requires maximizing risk, increasing the likelihood of poorly-timed investment decisions during periods of volatility and ultimately resulting in the underperformance gap revealed by Morningstar. With these things in mind, we believe a better approach when crafting an investment strategy is to focus on optimization rather than maximization. That may mean taking on less risk within a portfolio or sacrificing short-term performance by avoiding speculation. But if the goal is long-term, durable investment returns, then reducing the likelihood of strategy abandonment is critical. Surviving the low ends is necessary for any investment portfolio to compound consistently over time. Ben Trotsky, former bond manager at PIMCO, coined the term ‘strategic mediocrity’ in describing his investing strategy, which was to effectively outlast his peers over the long-term, tortoise and the hare style. As fiduciaries responsible for preserving and compounding capital over multiple generations, our investment team must take the same approach. Strategic mediocrity and a focus on optimization rather than maximization can allow the 6-foot-tall man to safely cross the stream that is 5-feet deep on average.

Disclaimer:?Trust and Investment Management Services are not a deposit, not FDIC insured, nor insured by any federal government agency, not guaranteed by the bank or its affiliates, and may lose value. This general market commentary is intended for informational purposes only and should not be considered investment, financial, or legal advice.

We believe the information contained within this material to be reliable but do not warrant its accuracy or completeness. Opinions and views expressed herein reflect our judgement based on current market conditions and are subject to change without notice. Past performance is not indicative of future results. Additional risk considerations exist for all strategies, and the information provided is not intended as a recommendation, or an offer or solicitation to purchase or sell any investment product or service.