In his book – Wining The Loser’s Game, Charles Ellis discusses the problem with chasing Icarus-Like returns. Here’s an excerpt from the book:
Once an efficient portfolio has been constructed at the level of risk that is appropriate for a particular investor, it would not make sense to incur more individual-stock risk or stock-group risk unless such risk is directly associated with a specific opportunity to capture sufficient extra return.
The amount by which market risk and return can be magnified in a portfolio by investing in moderately higher-market-risk, more price-volatile stocks is not spectacular, but the benefits over the very long run can be worthwhile. A portfolio with a market risk that is 20 percent greater than the overall market average is feasible. A market risk much higher than that would be difficult to design into a portfolio while keeping the portfolio well diversified.
The number and variety of stocks needed to achieve good diversification and provide that much additional market risk are simply not available in the market.
The expected “extra” rate of return for a portfolio with 20 percent more than average market risk would be, on average and over the very long term, 1.2 percentage points annually.1
If 1.2 percentage points of incremental return over the market average return seems modest, remember that no sizable mutual fund has achieved that amount of annual incremental return over any sustained period!
The great secret of success in long-term investing is avoiding serious, permanent loss. The saddest chapters in the long history of investing are tales about investors who suffered serious losses they brought on themselves by trying too hard or by succumbing to greed. Leverage is all too often the instrument of self-destruction.
Investors will be wise to remember the great difference between maximization and optimization as they decide on their long-term strategy. Icarus was a maximizer, as were many of history’s destroyed “fortune builders” who, like Hamlet’s hapless military schemer, were hoisted with their own petards.2
1. 20 percent x 6 percent return on equities over and above the risk-free rate of return = 1.2 percent incremental return.
2. A petard was a small bomb.
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