Lesson 2: Diversification is always working; sometimes you like the results, and sometimes you don’t.
Everyone is familiar with the benefits of diversification. It’s been called the only free lunch in investing because, done properly, diversification reduces risk without reducing expected returns. However, once you diversify beyond a popular index, such as the S&P 500, you must accept the fact that, almost certainly, you will be faced with periods, even long ones, when a popular benchmark index, reported by the media on a daily basis, outperforms your portfolio. The noise of the media will then test your ability to adhere to your strategy.
Of course, no one ever complains when their diversified portfolio outperforms the popular benchmark—experiences positive tracking error. The only time you hear complaints is when the diversified portfolio underperforms—experiences negative tracking error.
As the table below demonstrates, 2018 was just such a year. To show the returns of various equity asset classes, I used Dimensional’s asset class funds. Returns data is from Dimensional. (Again, in the interest of full disclosure, my firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)
In some ways, 2018 was similar to 1998 in that U.S. stocks outperformed international stocks, and large and growth stocks outperformed small and value stocks. What’s important to understand is that we should want to see a wide dispersion of returns. If we didn’t, when one asset class performed poorly, we could expect them all to perform poorly, and to similar degrees.
Wide dispersions of returns also provide us with opportunities to rebalance the portfolio, buying the underperformers at relatively lower prices, at a time when their expected returns are now higher, and selling the outperformers at relatively higher prices, at a time when their expected returns are now lower. Of course, that requires discipline, which is a skill that most investors don’t possess. The table below demonstrates the importance of adhering to your plan.
Lesson 3: Don’t make the mistake of recency. Last year’s winners are just as likely to be this year’s dogs.
The historical evidence demonstrates that individual investors are performance chasers—they buy yesterday’s winners (after the great performance) and sell yesterday’s losers (after the loss has already been incurred). This causes investors to buy high and sell low—not exactly a recipe for investment success. As I wrote in my book “The Quest for Alpha,” this behavior explains the findings from studies that show investors can actually underperform the very mutual funds in which they invest.
For example, in a July 2005 study published in “Morningstar FundInvestor,” Morningstar found that in all 17 fund categories it examined, the returns earned by investors were below the returns of the funds themselves. Unfortunately, a good (poor) return in one year doesn’t predict a good (poor) return the next year. In fact, great returns lower future expected returns, and below-average returns raise future expected returns.
Thus, the prudent strategy for an investor is to act like a postage stamp. The lowly postage stamp does only one thing, but it does it exceedingly well—it adheres to its envelope until it reaches its destination. Similarly, investors should adhere to their investment plan (asset allocation). Sticking to one’s plan doesn’t mean just buying and holding. It means buying, holding and rebalancing—the process of restoring your portfolio’s asset allocation to your plan’s targeted levels.
Using Dimensional’s structured mutual funds, the following table compares the returns of various asset classes in 2017 and 2018. As you can see, sometimes the winners and losers repeated, but other times they changed places.
For example, the best performer in 2017, emerging markets, fell to 6th place in 2018; and the worst performer in 2017, U.S. real estate securities rose to first place in 2018. Returns data is from Dimensional. (Once more, in full disclosure, my firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)
Later this week, we’ll resume with lessons four through seven.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.