If you were given the choice of investing in one of two portfolios, which would you choose? Portfolio 1 consists of an equal dollar amount in the 10 S&P 500 subindustry indexes that posted the worst performance last year. Portfolio 2 contains the 10 best performers from 2006. Many investors would choose the worst-performers portfolio, on the expectation that such a beaten-down group is ripe for recovery. Those choosing the best performers might believe that momentum is on their side. Which does history say is the better choice?
During the past 37 years, the S&P 500 posted a 7.7% compound annual growth rate (CAGR) - price appreciation only, no dividends reinvested - and had a 16.3 standard deviation, which is a measure of volatility. Its risk-adjusted return (return divided by risk) during this period was 0.47. (The higher the number, the better.)
An investor who chose the "worst" portfolio saw a 7.8% CAGR but an increase in volatility. This portfolio beat the market only 49% of the time, as shown in the frequency of outperformance column, and its risk-adjusted return of 0.30 was dramatically lower than that of the S&P 500. Hence, the return was not worth the risk, in our opinion.
The investor who selected the "best" portfolio, however, received a 13.8% compound return, for an annual outperformance of about six percentage points. And despite an increase in volatility, we believe the risk was worth it because the risk-adjusted return was higher than that of the S&P 500. Finally, this portfolio beat the market seven times out of every 10.
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