Performance Chasing Versus Diversification

Performance Chasing Versus Diversification

Posted On January 25, 2024 By Admin In Behavioral Finance, Portfolio Management /  

The chart below highlights the perils of performance chasing versus the benefits of diversification. This chart from JP Morgan shows the annual performance of major investment categories from 2008 through 2023. It includes US Stocks (large and small), Developed Markets, Emerging Markets, Fixed Income, Cash, Real Estate, and even Commodities.

The results are all over the place. What is often the best investment in one year turns out to be the worst investment the next year. Consider:

  • Commodities were the best category in 2022 and the worst in 2023.
  • Real Estate Investment Trusts (REITs) went from worst in 2020 to best in 2021, and back to worst in 2022.
  • Cash was the worst investment in 2016 and 2017, then the best in 2018, and back to the worst in 2019. It was however, positive, in each of these years!
  • Emerging Markets Stocks were the worst category in 2008 then the best in 2009. EM was the best in 2017 and then the worst in 2018.

Past Performance Is…

Today a lot of investors are experiencing FOMO because they didn’t own enough Tech stocks in 2023. A small number of stocks (seven, in fact) crushed the rest of the US stock market as well as the other categories. There is a palpable frustration to have a diversified portfolio and lag funds which are concentrated in a few growth names.

This January, investors are looking at their 401(k) or IRA statements and wondering if they should make a change. They see that the XYZ Growth fund was up 40% last year, and it is tempting to drop their diversified portfolio in favor of a fund that performed better last year.

This is performance chasing. It is abandoning the benefits of diversification in favor of betting on what has been hot recently. And it is hazardous to your wealth. Often, what is at the top one year will under-perform in the following years. If you chase performance, you will often buy a hot sector just as it is about to go cold. And then you find that you are switching funds every year because there is always a “better” fund. Just remember, past performance is no guarantee of future results!

Valuations Matter (Eventually)

Today’s market has some similarities with the Tech Bubble in 1999. People got very excited about a relatively small number of Tech companies and bid them up to expensive valuations. Those stocks became quite bloated and drove up the multiple of the entire US stock market. In the frenzy, there were a lot of people who bought tech funds at or near the top. They were late to the party and missed the big gains in 98 and 99, but were invested very aggressively when the bubble burst in 2000.

Stocks were so overvalued that we had three years of subsequent losses in the S&P 500: 2000, 2001, and 2002. That had never happened before. The amount of wealth that was wiped out in the Tech Bubble was truly staggering. The bubble seems pretty obvious in hindsight, but human nature has not improved since 1999. We are prone to make the same mistakes.

I don’t know that we are in a new Tech Bubble, but the lesson remains the same. We don’t chase performance, we invest based on valuation. Our portfolios are diversified across many categories, and rebalanced annually. We use index funds and focus on keeping costs and taxes low.

Our tilts towards areas of greater expected return actually means that we do the opposite of performance chasing. We prefer to buy what is on sale, cheap, and out of favor. We are looking for the categories in the lower half of the chart to return to being in favor. This is a disciplined, long-term process which has worked over time. (See: Our Investment Themes for 2024.)

Reversion To The Mean

In the short run, expensive stocks can still go up in price if there are enough buyers. That’s where we are today, but the party won’t last forever. US Growth stocks are expensive and have a lower expected return going forward. The expensive valuations are expected to gradually revert down towards historical levels. And the inexpensive categories have room to return to more normal valuations. The chart below shows Vanguard’s projected returns over the next 10 years.

Over the next decade, Vanguard forecasts US Equities to have an annualized return of 5.2%, versus 8.1% for International Equities. With performance chasing is investors are looking backwards. They project recent returns into the future (Google “recency bias“), rather than recognizing that returns average out over time. Instead of piling into the hot stocks, sectors, or categories, investors should stay diversified and also own the categories which have under-performed.

Performance Chasing is a constant temptation because a diversified portfolio will (by definition) always lag some small subset of the market. There is always a hot category. Unfortunately, no one has a crystal ball to predict what will be the next hot investment and jumping around is more likely to harm than help returns. Thankfully, investors are well-served by ignoring the noise and staying on course with a diversified portfolio designed for their needs and long-term goals.

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Are Equities Overvalued?

Posted On January 5, 2015 By Admin In Behavioral Finance, Portfolio Management /  

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In last week’s blog, we reviewed the fixed income market and discussed how we are positioned for the year ahead.  Today, we will turn our attention to the equity portion of our portfolios.  Perhaps the top question on most investors’ minds is whether the 5-year bull market can continue in 2015.  At this point, are equities overvalued or do they still have room to run?

I don’t think it’s useful to try to make predictions about what the market will do in the near future, but I’m certainly interested in understanding what risks we face and what areas may offer the best value for our Good Life Wealth model portfolios.  We use a “Core + Satellite” approach which holds low-cost index funds as long-term “Core” positions, and tactically selects “Satellite” funds which we believe may enhance the portfolio over the medium-term (12-months to a couple of years).

The US stock market was a top performer globally in 2014.  The S&P 500 Index was up over 13% for the year, and US REITs (Real Estate Investment Trusts) returned 30%.  Those are remarkable numbers, especially on the heels of a 32% return for the S&P in 2013.  With six years in a row of positive returns, valuations have increased noticeably for US stocks.  The S&P now has a forward P/E (Price/Earnings ratio) of 18, slightly above the long term average of 15-16.

While US stocks are no longer cheap, that doesn’t automatically mean that the party is over.  With a strong dollar, foreign investors are continuing to buy US equities (and enjoyed a greater than 13% gain in 2014, in their local currency).  The US economic recovery is ahead of Europe, where growth remains elusive and structural challenges are firmly in place.   Compared to many of the Emerging Market countries, the US economy is very stable.  Emerging economies face a number of economic and political issues, and struggle with declining energy prices, often their largest export.

US Stocks remain the most sought-after.  While today’s P/E is above average, “average” is not a ceiling.  Bull Markets can certainly exceed the average P/E for an extended period.  And given today’s unprecedented low bond yields, it’s tough to make a comparison to past stock markets; equities are the only place we can hope to find growth.  Current valuations are not in bubble territory, but it seems prudent to set lower expectations for 2015 than what we achieved in the previous five years.  And of course, stocks do not only go up; there are any number of possible events which could cause stocks to drop in 2015.

Given the current strength of the US market, you might wonder why we own foreign stocks at all.  They certainly were a drag on performance in 2014.  In Behavioral Finance, there is a cognitive error called “recency bias”, which means that our brains tend to automatically overweight our most recent experiences.  For example, if we did a coin-toss  and came up with “heads” four times in a row, we’d be more likely to bet that the fifth toss would also be heads, even though statistically, the odds remain 50/50 for heads or tails.

Checking valuations is a important step to avoid making these types of mistakes.  Looking at the current markets, Foreign Developed Stocks do indeed have better value than US stocks, with a P/E of 15.5 versus 18.  And Emerging Market stocks, which were expensive a few short years ago, now trade at an attractive P/E of 13.  We cannot simply look at which stocks are performing best to create an optimal portfolio allocation.  Diversification remains best not just because we don’t know what will happen next year, but because we want to buy tomorrow’s top performers when they are on sale today.

Our greatest tool then is rebalancing, which trims the positions which have soared (and become expensive), to purchase the laggards (which have often become cheap).  So we’re making very few changes to the models for 2015, because we want to own what is cheap and want to avoid buying more of what is expensive, even if it does continue to work.  We will slightly reduce International Small Cap, and add the proceeds to US Large Cap Value.  US Small Cap has become quite expensive, but small cap value now trades at a bit of a discount (or is less over-valued, perhaps), so that is another shift we will make this year.

Each year, I do an in-depth review of our portfolio models and I always find the process interesting and worthwhile.  This year, looking at relative valuations in equities reminds me that our best path is to remain diversified, even if owning out-of-favor categories appears to be contrarian in the short-term.

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