Diversification vs. Chasing Performance: And the winner is…

2016-03-16 Annual Asset Class Performance1Our regular readers have come to expect an updated version of this “Asset Class Performance” chart about once a year.  (Click on it to enlarge.) It’s a little like running the Charleston’s Cooper River 10k Bridge Run once a year.  It puts things in perspective.  Things that go up, also go down.

Take a look at REITs in 2006 and 2007. From first to last in performance. And, Emerging Markets from 2007 to 2008, same thing. Bonds were almost a top to bottom in 2008 and 2009 and after Emerging Markets topped in 2009, it took them two years to hit bottom. Do we see a trend here?  Yes, we do.

As we discussed at our seminars in October, we’re all hard wired to want to jump on to winners and discard current losers.  We have a short memory – we place more emphasis on recent performance rather than long-term.  Furthermore, our emotions are aided and abetted by the media- always happy to make an up-and-comer sound like the perennial winner for decades to come and an asset class that is struggling to appear to have no hope of ever turning around.

We saw it earlier this year.  After a fairly dismal year of returns for all asset classes in 2015, 2016 stock markets got off to a slow start and then accelerated downward as pessimism, exacerbated by uncertainty in the world economy, interest rates, oil prices, U.S. Presidential politics and the media drove down performance until the second week in February.  And then, the pendulum starting swinging the other way, pushing markets upwards for the last four to five weeks.

A lot can happen in just a few years.  If we were looking at this same chart for the ten years ended December 31, 2013, the top performers were much different.   Emerging markets were the top performer, followed by mid caps, small caps, REITs, international stocks and then large caps.  Going back even farther, large caps for the ten year period 2000-2009 were negative.  Of course, they’ve come back strongly in the last five years, up 12% per year.

The key is that there is no “silver bullet”- that is, there is not one asset class that provides a simple and magical solution to asset allocation.  To illustrate this, let’s say we had decided to “chase performance” by investing 100% each year in the top performer of the prior year.  We can start with the results of 2006 and invest in REITs in 2007.  For 2008, we’ll invest in Emerging Markets, the top performer in 2007, and so forth for each of the next nine years.  The result: an annualized return of -4%.

Okay, how about if we invest in the most underperforming asset class instead.  We’ll invest in TIPS in 2007, REITs in 2008 and so forth. Our result is only slightly better, -3% annualized return.

Lastly, how about being a disciplined investor, using all asset classes and maintaining a balanced allocation, for example, of 50% equity, 35% fixed income, 10% REITs and 5% commodities for ten years?  The result:  An average annual return of 5.2%. With annual inflation at 1.6% for the decade, that’s quite a respectable real return of 3.6% per year for the last ten years.

The moral of the story is always the same.  Don’t follow your emotional biases.  Don’t chase performance.  Don’t try to time the market.  Instead, focus on what you can control:

  • Maintain an investment plan that fits your needs and risk tolerance
  • Identify an appropriate asset allocation target mix
  • Structure a diversified portfolio between and within asset classes
  • Reduce expenses and turnover
  • Minimize taxes
  • Rebalance regularly
  • Stay invested
  • Stay disciplined

If you have any questions or need any assistance with any of the above, please let us know.  At DWM, we’re ready to help and are passionate about adding value.