Why Buffett's losing years are even more important than his winning ones

Even the best ideas flounder some of the time.

The overwhelming majority of top mutual fund managers — those who had the best record over a decade — spent at least three years lagging well behind others during that time, according to Joel Greenblatt, a hedge fund manager and author of the "The Little Book That Still Beats the Market."

More than three-fourths of these star managers spent three years at the very bottom of the performance ladder, something short-term-minded investors tend to flee. But too bad for them. These managers all outperformed over the longer run — the decade-long period through the end of 2009.

That is a lesson for all of us. Sometimes success means sticking to your plan even if things are not working out so well at the moment. Given the constant ups and downs of the market, strategies that outperform all the time should be looked at with skepticism. Investing is a long-term commitment that involves risk as well as reward. This is relevant today because active managers have had a few very difficult years in beating their benchmarks; and the flow into passive investing continues to be a trend.

Take a look at the top-performing U.S. diversified stock fund of the 1980s, Ken Heebner's $3.7 billion CGM Focus Fund (NASDAQ:CGMFX-O). It was up 18 percent annually, but the average investor lost 11 percent a year because impatient people kept leaving and coming back based on the ebbs and flows of short-term returns. When performance is up, investors pour their money into a fund. And when it is down, they sell.

CGM was up a stunning 80 percent in 2007, focusing on a super-concentrated basket of 25 stocks. Investors put $2.6 billion into it in 2008 — the year the financial crisis sent global stock markets into a tailspin. CGM fell 48 percent that year, and predictably, investors pulled $750 million from the fund in 2009. But 2009 would prove to be a rebound both for the markets and the fund's performance. Over the past one, three, five and even 10-year periods, CGM Focus Fund has trailed the S&P 500 Index (^GSPC), but over the past 15 years it is still outperforming the S&P 500 by two percentage points and is ranked fourth overall in its fund category by Morningstar.

Wise investors would resist the impulse to flee. A portfolio of hand-selected stocks or managers is supposed to deliver something the benchmark index does not. When the benchmark does well, the portfolio might trail it. When the benchmark does poorly, the portfolio might outperform. Reaching for returns that beat the benchmark requires the emotional discipline to stick with an investment manager through thick and thin, knowing that no strategy can beat the market all the time.

Even Warren Buffett , the billionaire head of Berkshire Hathaway (BRK-A) who is followed by millions of investor devotees, has bad years. Newfound Research analyzed Buffett's track record and found he underperforms the broad index about once every three years and he's had 10 periods when he missed the benchmark by 10 percent or more over a significant period of time.

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But those who stuck with Buffett through the years have benefited from being patient. From March 1980 to October 2016, Berkshire Hathaway's A shares delivered annual return of 20.2 percent, nearly 10 percent more annually than the S&P 500, according to Newfound Research. On Tuesday morning, A shares of Berkshire Hathaway briefly passed $250,00 0, a landmark eclipsed 54 years and a day after Buffett bought his first shares of then-textiles company Berkshire.

This dispels the notion that short-term underperformance is bad. After all, would you fire Buffett from managing your portfolio just because one of his current investments has taken a hit lately? Buffett famously says investors should take advantage of downturns to buy what others are selling.

Risk-free outperformance isn't possible. A manager with an expected annual outperformance of 3 percent has a four-in-five chance of lagging the benchmark by 10 percent or more at least once in a five-year period, according to Newfound Research's analysis. Shifting in and out of that manager's fund just because he underperforms would be costly. As hedge fund manager Greenblatt notes, there isn't a correlation between a manager's three-, five- and 10-year records in the past and how they will do in the future. What's more important is understanding the strategy and having the confidence to follow it long-term.

But truth be told, many investors, including professionals, can find it difficult to grasp the facets of an investment strategy and tend to overweight recent returns. (For the record, Berkshire Hathaway is up 25 percent this year — 15 percent since November — with the Trump election boom in bank stocks a big part of that move up .)

Even if investors do understand what goes into the investment approach, it can be hard to distinguish between luck and skill. This is why indexing can be a good option for many investors, assuming they can stick with an index through the market's good and bad times. However, for those investors who seek outperformance over the market and are willing to tolerate relative underperformance over periods of time, the key ingredient to success is staying committed to an active strategy or manager when it underperforms.

In the end, investors should understand and accept how much risk they are willing to take and build a portfolio that tries to match it and stick to it for the long-term. An investor who understands there is a certain element of risk to investing is more likely not to panic when markets go awry.

— By John Reese, co-founder at Validea Capital Management, which manages the Validea Market Legends ETF (VALX (VALX))

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