When investors look at their final statements at year-end, there is bound to be lots of discussion about how their portfolios performed. And, as has become usual in the past couple of years, there will be questions about and comparisons between the U.S. stock indices and that performance. In other words, how can the Dow or the S&P be up by that much and I am “only” up by X?
Admittedly, I added the quotation marks there. But it is a real and valid question. What it gets to, though, is a deeper question beyond how your investments did this year: what should we expect from our investments—and why?
Let’s start with the past year
If you held only the Dow Jones Industrial Average (DJIA), you would have been up by 28 percent, the Nasdaq by almost 30 percent, and the S&P 500 by “only” 21 percent. If you held the most common bond index, the Bloomberg Barclays U.S. Aggregate Bond Index (the Agg), you would have made about 3.5 percent. A 60-percent stocks/40-percent bonds allocation between the S&P 500 and the Agg, which is a reasonable shorthand for a balanced portfolio, would therefore have returned about 14.5 percent.
That balanced return, at 14.5 percent, is a heck of a lot less than the stock indices. Why should we settle for that? Perhaps we should invest only in stocks or at least put more in stocks. That would certainly generate higher returns. So, why aren’t we taking more risk? This is becoming a more common discussion as stocks rise higher and higher.
Why stop there?
If that is the plan, though, why stop there? The MSCI Emerging Markets Index was up almost 38 percent in 2017. If we are focusing only on return—and only on the last year—we should be fully in emerging markets. This is the logical conclusion of the argument that we should put more money in stocks.
It is, however, crazy talk. In any given year, stocks are likely to outperform—but not always. The S&P 500, for example, has done very well over the past couple of years, but it has also periodically done quite poorly. And, of course, if you include 2000 and 2008, it is clear there is very real risk that goes with those high returns. You see the same thing with emerging markets, with high gains in some years and heart-stopping declines in others. You never know which it will be. Focusing on the asset classes with the highest returns can also result in the largest losses, as we have seen over and over again.
Diversification rather than focus
The answer to this problem, of course, is diversification instead of focus. By spreading your bets around, you are less exposed to the standout investments but also less damaged by the bad ones. You will make less and lose less. Over time, your returns will fall within a narrower range. You can see that in the chart below:
Source: Novel Investor
Note how the light-gray box, the asset allocation (AA) diversified portfolio, is never the best performer. But it is also never the worst.
For most people who are focused on achieving their goals in a disciplined way over time, this is the right road. Unfortunately, however, there is one very real caveat: you will never (never!) match the best performers out there. In that sense, you are condemned to underperform. On the other hand, you are also guaranteed to outperform the worst performers.
So, the answer to the question “why did I underperform the indices?” is therefore quite simple—by design. To avoid the price declines we know happen, you have to underperform the best performers. Mathematically, it has to be that way.
Keep an eye on the destination
Over time, a diversified portfolio is not only easier to live with but also a better investment solution. It certainly doesn’t make it any more tolerable to see the indices growing that fast, though. When I am driving on the highway, it is maddening to see people blowing by me in the fast lane. But now that I’m older, I stay focused on the destination—as well as the very real chance those drivers may crash—and just keep going the speed limit. Well, close to it anyway.