What the pros do when they are underperforming (other than panic)

Three weeks ago, we had a few of our worst days relative to the market in many months. How bad is very bad? To put this in perspective, when I managed a large mutual fund, gaining or losing 1/5 of 1%, or 20 basis points, compared to the S&P 500, would be a meaningful daily move. Now, with only 35 stocks in our portfolio, few of which are weighted close to the S&P 500, we can easily move 50 basis points in a day on either side of the market.

When we’re really hitting on all cylinders, or totally out of sync with the market, that amount can double. That’s great when the screen is green, but when we suffer a relative loss of 1% in a day, it’s enough to make me and any of my non-masochistic partners switch the screen views on our desk to old episodes of “The Office.”

So, on one of those particularly bleak days in late May, I began worrying (one of my constant states of existence) about what would happen if we began to trail the market at that rate, for many days in a row. Should we toss our “best” ideas, shift hard defensively, and alter our fairly aggressive, mostly fully invested portfolio? Rather than sit around depressed and panicked, I decided to check the numbers, and review exactly what happened during our last period of underperformance.

Dissecting your past mistakes

The fourth quarter of 2016, the one in which Donald Trump surprised most of the world by winning the presidential election, was the worst quarter we’ve had during the past nine years, on a relative basis. It seemed that if I examined some of the data surrounding that decline and what followed in the quarters afterward, I might learn something useful.

Our growth-heavy portfolio never had a chance that quarter; we lost nearly 4% to the index. Investors rejoiced about a potential rollback of financial regulation and revitalization of U.S. manufacturing, a constant reference in Trump’s “Make America Great Again” catchphrase. Banks, industrials, and transports literally soared, and tech, digital darlings, and healthcare stocks sickened on the fear of increased scrutiny, price controls and presidential wrath.

Seven of the top ten performing stocks in the S&P that quarter were banks, plus an investment bank, a chipmaker, and an airline, with an average and median gain of 45%. In comparison, our top ten gainers averaged 19% with the median at 17% and only three financials on the list. We purchased two of those stocks the week after the election, admitting that our expectations of the next administration’s priorities and initiatives were totally wrong…

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