One of the hardest parts about investing is that prudent advice doesn’t always work. Risk management doesn’t always add value. Legitimate strategies can go long stretches where they don’t work very well. Diversification means you’ll always hate something in your portfolio. Junk stocks can outperform high quality companies depending on the starting prices and valuations.
The market environment we’ve seen over the past 5-7 years is a great example of this phenomenon. The stuff that’s been working well has basically been everything they tell you not to do as an investor.
Here are three things that have worked in this cycle:
1. Chasing Yield. Investors who have given up on high quality fixed income and instead adopted a “bond substitutes” portfolio have done quite well for themselves, despite the fact that chasing yield can be a recipe for disaster. Here are the trailing 5 year annual returns for some popular income investments:
- Dividend Stocks (SDY) +13.5%
- Convertibles (CWB) +8.9%
- REITs (VNQ) +10.7%
- Utilities Stocks (XLU) +10.5%
- Consumer Staples Stocks (XLP) +13.7%
High quality bonds (AGG) on the other hand are up just +2.8% per year in that time.
2. Not Rebalancing. When stocks go up in a near uninterrupted fashion, risk management techniques like rebalancing will seem foolish. If you look at a simple U.S. 60/40 stock/bond portfolio made up of the S&P 500 ETF (SPY) and the Barclays Aggregate Bond ETF (AGG), an annual rebalance back to target weights would have given you a return of 10.4% per year from 2009-2015. Had you just allowed both allocations to drift without rebalancing, the return would have been 11.0% per year.
3. Having a Home Country Bias. Over the previous 5 years U.S. stocks, as measured by Vanguard’s Total Stock Market ETF (VTI), are up 12.8% per year. In that same time, the Vanguard Total International Stock Market ETF (VXUS) is up just 4.0% per year. The U.S. has been outperforming the rest of the world by almost 9% a year for half a decade.
So the best approach since 2009 or so has been to chase yield, avoid risk management and steer clear of diversification.
It’s no wonder investors have a hard time sticking with a disciplined approach to portfolio management. The markets are constantly tempting us to be impatient, chase performance, abandon discipline and give up on the management of risks.
I’m not saying you should never own income-producing assets beyond high quality bonds. But you have to understand the excess risk you are accepting to shoot for excess returns.
And I’m not saying that you have to rebalance your portfolio on a set schedule. There are certainly other ways to think about rebalancing. But had you allowed your portfolio to drift like I laid it out in the above example, you would now have a portfolio that’s 75% in stocks and 25% in bonds, a huge deviation from the target allocation weights.
Finally, there’s no right or wrong way to diversify your portfolio globally. But you have to understand that global diversification is a great way to spread the risks in your portfolio, even when it feels like it’s not working in the short-term. Diversification means always saying sorry about something.
It’s always going to be tempting to look at what just happened or what you wish you would have done to make your current decisions. It can feel more comfortable to go with the crowd or default to a what-have-you-done-for-me-lately portfolio. Markets have a way of almost forcing you to make errors and develop bad habits.
In his book, The Power of Habit: Why We Do What We Do in Life and Business, Charles Duhigg talks about why we develop habits in the first place:
Habits exist because the brain is constantly looking for ways to save effort. Habits allow our minds to ramp down more often.
The human brain is like any muscle in the body — it can get fatigued and can’t always operate at full speed. Willpower can be fleeting once decision fatigue sets in.
Allowing your mind to ramp down is a two-way street — it could lead to beneficial or poor habits depending on the types of routines you develop. Investors can find themselves in trouble if they’re blinded by hindsight when making portfolio choices and allowing bad habits to enter the decision-making process.
If you lucked out and piled into U.S. stocks, chased yield or avoided any form of risk management in recent years you’ve been rewarded. But now what? Just because something worked doesn’t alway make it a great decision.
The current trends will eventually reverse, leading investors to learn even more bad habits. Here’s Duhigg on how to ensure that you form the right habits and avoid the wrong ones:
Willpower becomes a habit by choosing a certain behavior ahead of time, and them following that routine when an inflection point arrives.
Those inflection points can be painful in the markets when you don’t know what you’re doing or have developed bad habits in the past. Sometimes the worst thing that can happen to an investor is they make money on their investments but for the wrong reasons.
Longevity in the markets comes from making good decisions over and over again even in the face of some occasional poor outcomes.
The Power of Habit
The Consequences of Risk Taking