The Challenge of Being Average

Mark Wendell |

By Mark Wendell and authorship rights attributed to Craig L. Israelsen, Ph.D. (MD Wendell Wealth Partners reprint by permission from the author, April 2014) Portfolio diversification is a virtue—but it can also be seen as a vice because it produces “average” results on a year-to-year basis.

Consider the annual performance of an equally-weighted 7-asset portfolio vs. the single-asset S&P 500 Index from 1970-2013 (see Figure 1). The blue bars represent the year-to-year returns of the S&P 500 Index and the maroon bars represent the returns of a 7-asset portfolio (comprised of US large and small stock, non-US stock, commodities, real estate, US and non-US fixed income, and cash).

The S&P 500 Index outperformed the multi-asset portfolio 55% of the time (24 out of 44 years). But, more than that, the annual margin of victory was often dramatic. For example, in 1998 the S&P 500 Index had a return of 28.58% while the multi-asset portfolio produced an annual return of 0.96%--a victory by over 2,700 basis points. The average margin of victory for the S&P 500 (in those years that it outperformed a multi-asset portfolio) was 833 basis points.

So, how is it that both end up with a 44-year performance that is basically the same? The S&P 500 Index had a 44-year average annualized return of 10.41% vs. 10.29% for the multi-asset portfolio. The answer is the down years—there were more of them for the S&P 500 (9 losses vs. 5 losses for multi-asset portfolio) and the depth of the plunge was far greater. The average negative return for the S&P 500 Index was -15.2% vs. -8.7% for the multi-asset portfolio. Very simply, negative returns are disproportionately more damaging to a portfolio than the counter balancing effect of positive returns of the same size. Let me explain.

Figure 1: Annual Returns of the S&P 500 Index vs. a 7-Asset Diversified Portfolio: 1970-2013 (Raw data source: Lipper)

A 20% loss requires a 25% gain to break even. A 50% loss requires a 100% gain to break even. A 75% loss requires a 300% gain to break even. Thus, the frequent outperformance of the S&P 500 Index compared to a multi-asset portfolio was essentially undermined by the frequency and magnitude of large negative returns in the S&P 500 Index. The large drawdowns of the S&P 500 Index offset its more frequent upside.

So, are “average”, diversified returns good enough? Yes, most definitely. But, the virtue of multi-asset “average” performance (like most virtues) only becomes fully apparent over time. The challenge of building a multi-asset portfolio is in the short-run, not the long-run. Said differently, a multi-asset portfolio will never outperform the best performing individual asset class in any given year, but in the long run, (historically speaking) it will win the portfolio return race with reduced risk. Multi-asset portfolios are steady, not flashy. Therein lies the problem: the best performing asset class of last year may create investor “envy” which can lead to “performance chasing”—which consists of reallocating all or a portion of their portfolio to last year’s winning asset class or strategy. Such an approach is nonsense—but so are a lot of things we humans do.

In a recent conversation with Mark Wendell, MD Wendell Wealth Partners in Westlake Village CA, he was asked to express his views on this subject: “Using diversifying techniques helps investors protect themselves from themselves—that is, employing diversification strategies will counter investors’ tendency to make the human behavioral error of focusing on the most recent performance and winner, rather than correctly and most importantly, focusing on attempting to achieve a smoother ride with superior longer-term results. This point is especially important when clients are pulling funds out monthly because volatility is not your friend; you may end up with a negative dollar cost averaging effect or a negative compounding result due to losses on some monthly payouts combined with distributions of interest and dividends. Most people do not realize the difference between investment risk and gambling hope, which is why I put so much emphasis on risk managed returns for my clients’ portfolios rather than stretching risk for higher total returns.”

The steady performance of the 7-asset portfolio represents the tortoise and chasing last year’s best performing asset class (among the seven asset classes in a diversified portfolio) represents the hare. Consider the results over the past 15 years (1999-2013). The tortoise had a 6.97% annualized return compared to a 4.68% 15-year annualized return for the hare.

Investment
Approach
15-Year Annualized Performance
HARE:
Performance Chasing by Investing in Last Year’s Best Performing Asset
(100% allocation to last year’s best asset among the seven asset classes)
4.68%
TORTOISE:
Invest in an equally weighted
7-asset portfolio
6.97%

 

Motto: building a broadly diversified portfolio is the only logical investment philosophy—both mathematically and emotionally. The emotional roller coaster caused by chasing the performance of individual asset classes should be self evident. The mathematics supporting the notion of less volatile portfolio performance have already been discussed—that is, large losses are disproportionately more damaging to a portfolio than positive returns of the same size.

There is one more aspect of diversification that I would like to briefly pursue: depth diversification vs. breadth diversification

The S&P 500 Index is a diversified collection of 500 stocks—all of which fall within ONE asset class: large cap US stock. This represents diversification depth. It’s important, but breadth diversification is more important. Breadth diversification is achieved when multiple asset classes such as stocks, bonds, and diversifiers are combined together—precisely the logic of a multi-asset investment portfolio. A properly built portfolio needs both depth and breadth diversification. Depth diversification is achieved by using mutual funds and/or ETFs while breadth diversification is achieved by using a wide variety of “depth diversified” mutual funds.

Diversification: Depth vs. Breadth

Why is breadth diversification important? Notice the excellent performance of the S&P 500 Index “hare” in 1999. Depth outperforms breadth over short time frames (such as in 2003, 2006, and 2009-2013).

However, good years are sometimes followed by meltdowns—as occurred in 2000, 2001, and 2002 for the S&P 500 Index. The “tortoise” 7-asset portfolio underperformed in 1999 but came through 2000-2002 relatively unscathed. In the end, the 7-asset portfolio—which represents breadth diversification— finishes over $7,600 ahead over the past 15 years.

Large cap US stock (i.e., S&P 500 Index) is an important “depth” ingredient within a diversified portfolio, but the S&P 500 Index—by itself—is not a diversified portfolio. Inasmuch as the S&P 500 Index has annually outperformed a multi-asset portfolio over the past five years it is important to keep a longer term perspective to appreciate the value of breadth diversification. Investors who fail to do so are susceptible to performance chasing.


Craig L. Israelsen, Ph.D. is an Executive-in-Residence in the Financial Planning program at Utah Valley University. He is the developer of the 7Twelve Portfolio.