CFA Program Curriculum, Level II, Derivatives and Portfolio Management:
Consider the results of the following two different investment strategies:
- An investor who put $1,000 in 30-day commercial paper on January 1, 1927, and rolled over all proceeds into 30-day paper (or into 30-day T-bills after they were introduced) would have ended on December 31, 1978, fifty-two years later, with $3,600.
- An investor who put $1,000 in the NYSE index on January 1, 1927, and reinvested all dividends in that portfolio would have ended on December 31, 1978, with $67,500.
Suppose we defined perfect market timing as the ability to tell (with certainty) at the beginning of each month whether the NYSE portfolio will outperform the 30-day paper portfolio. Accordingly, at the beginning of each month, the market timer shifts all funds into either cash equivalents (30-day paper) or equities (the NYSE portfolio), whichever is predicted to do better. Beginning with $1,000 on the same date, how would the perfect timer have ended up 52 years later?
This is how Nobel Laureate Robert Merton began a seminar with finance professors 25 years ago. As he collected responses, the boldest guess was a few million dollars. The correct answer: $5.36 billion.