The ceiling of stock returns

A question investors often wonder about, is how much money one can make with an investment in stocks, and active portfolio management. While there is no general answer to this question, we will still attempt to provide some guidance here.

Our crystal ball

There are many different approaches to investing, which will lead to very different results. For the purpose of this post, we are making the following assumption:

A good friend gives us a magic crystal ball, perfectly predicting the future of the stock market. We use this crystal ball, to tell us which of the 300 most liquid US stocks will perform the best in the next quarter. We then invest our money equally weighted in 1, 3, 5, 10, or 20 of these stocks.

What a wonderful dream. How well will we do? Let’s plot our quarterly performance, compared to SPDR’s S&P 500 ETF, SPY, as a proxy for the stock market:

ceiling quarterly perf

As we can see, our results are outstanding: Over the past 10 years, we could have made 35% each quarter, while still being diversified across 20 stocks. So our crystal ball makes us a lot of money!

Even better, we notice that even between Q4/2007 and Q1/2009, when the S&P 500 was incurring large losses, we could still made a lot of money. There is always a bull market somewhere.

But soon thereafter, our crystal ball loses some of its appeal: Even our best picks have a positive correlation (beta) with the S&P 500. While our quarterly return never becomes negative, the performance is quite ragged, with dips in exactly the same places as the S&P.

The thrill is gone

It becomes quite clear that even with our crystal ball, we will still be faced with drawdowns. How bad can those be, knowing that by the end of the quarter we will always make a profit? Let’s have a look:

ceiling quarterly dd

So even the very best performing stock picks come with quite a bit of volatility. Unless we diversify across 5 or more stocks, our portfolio’s volatility will exceed the volatility of S&P 500.

Takeaways

Of course there is no crystal ball. However, there are important takeaways from this thought experiment:

  • There is always a bull market somewhere.
  • During market downturns, even the best performing stocks have a positive correlation to the market.
  • Best performance is not synonymous with low volatility.
  • Even if we can foresee the future, diversification remains crucial.

We very much hope that this post provided some valuable insight into the possibilities of active stock trading. At Bertram Solutions, we pride ourselves in doing independent research, and this post is a good example of our approach to analyzing investments.