How Hard is it to Build a Terrible Portfolio?

Monday, November 26, 2012 at 10am
By John Friedman

Over the years I’ve noticed that most people’s 401k plan portfolios tend to do about the same — they tend to pretty closely track the market as a whole, and ultimately each other, especially if given enough time.

Many of these plans tend to offer a middle-of-the-road menu of mutual funds, including some star funds, surely, but also some has-been funds and some not-so-star funds that are probably on the 401k’s menu of funds because the 401k seller made it attractive for the 401k plan buyer to choose them, all of which, in aggregate, tend to amount to a whole lot of plain vanilla, middlin’ investing.

In the past the funds in 401k plans were mostly actively managed funds, which means that the managers of the funds tried to out-perform their peers by either (a) having better absolute performance than their peers (which is the marketing-centric approach, because people love to see big numbers, don’t’ch’ya know) or by (b) having better risk-adjusted performance (which is the more financial-health-centric approach, and is less about big numbers than the market-centric approach because it’s far harder to describe and a lot less sizzley for marketing purposes) (briefly: a fund can have better risk-adjusted performance by either (1) having better performance than its peers but with equal or less risk than its peers, or (2) the same performance as its peers but with less risk than its peers).

More recently most plans also include passive index funds, which, rather than seeking to outperform their peers, instead seek to mirror the performance of a specific chunk of the worldwide stock and bond markets. Common chunks so-tracked are the overall American stock market, the overall American bond market and the all-global-stock-markets-minus-the-overall-American stock market. And there are many, many more.

So while managers of active portfolios make decisions throughout the market day and non-market hours about how to outperform the market, the managers of passive portfolios have a much narrower (though by no means simple or easy) charge: they instead seek to make sure that, at the end of the fund’s operations on each market day, the fund’s portfolio mirrors the composition of the overall market chunk the fund is seeking to mirror, and then they go on their merry way the rest of the day and have a nice evening.

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All of this got me thinking about a little thought experiment. Hmmm . . .

The starting point for the thinking is the experience I mentioned above — that, once you put all these ingredients together in whatever proportions you wish, you mostly find that the portfolios tend to do about the same, and that they tend to, more or less and given enough time, fairly closely mirror the overall market.

So they congeal into a mostly-market-mirroring mix — an M-M-MM.

So how hard would it be, I wondered, to build a really badly performing portfolio out of these same basic building blocks? Clearly it’s hard to build a really wonderfully performing portfolio out of these basic building blocks — they’re too plain vanilla and too middle-of-the-road to provide much opportunity for goosing the portfolio’s performance. They gravitate towards an M-M-MM.

So . . . is it symmetrical? Could you build a really bad portfolio out of these chunks? 

Could someone who has consistently proved herself/himself to be a really great fund-picker also succeed at the Building-a–Terrible-Portfolio Challenge?

So let me make this BaTPC more concrete and more basic still: if you have fifteen ordinary mutual funds with average performance and which are not very narrowly focused on a single small chunk of the market — i.e. fifteen of the sorts of mutual funds you often seen in 401k plans — can you succeed at building a gosh-awful portfolio out of those components? Can you pick losers as well as winners? And aren’t the two picking-tasks — going for excellence and going for terribleness — the same or nearly the same task?

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I don’t know the answer to these questions. I am a generalist, not a money manager.

But I think a good money manager should have a lot to say about this topic, including some rocket science’y sorts of things as well as some battlefield and licking-my-wounds sorts of stories.

Any comments?

 

About 700 words (about a seven minute read, sans linked-to-content and sans doing much on the BaTPC thought experiment)

 

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