Back in my institutional consulting days I spent a lot of time analyzing the performance of active managers.
Most of the endowments, foundations and pension plans were trying to beat the market and beat their benchmarks.
The investment committees and boards for these non-profits needed some way of monitoring all of their stock, bond, hedge fund and private asset managers so they often came up with grading scales and watch lists.
The outperformers would have a green light. The middling managers would have a yellow light. The underperforming managers would have a red light. Each quarter the numbers would be updated based on performance against the benchmarks.
Sometimes a strategy like this can work by keeping you invested in the best-performers and helping you cut loose the losers. But that momentum game can only work for so long because outperformance is fleeting in the markets.
Even the world’s best investors underperform at times.
That’s how you get a situation like this:
You hire a new manager that just outperformed because the returns look amazing and then they go on to underperform after you hire them. Not everyone does this of course, but it happens more often than you think.
Every year SPIVA publishes a persistence scorecard that looks at how often manager outperformance in one period is followed by future outperformance.
Here are the numbers for U.S. stock market funds over consecutive three year periods:
So 69% of funds in the top quartile of returns for 2023 remained in the top quartile in 2024. But just 33% were still in the top quartile in 2025.
Now look at these numbers over five years:
Starting in 2021, there were basically no funds that remained in the top quartile 3, 4 and 5 years later. Less than 10% of funds could stay in the top half of performers for five consecutive years.
So you have to get used to the fact that nothing and no one can outperform the markets on a consistent basis. This is what makes active management so difficult. Stock-picking is hard, but it might be even harder to pick the managers that will outperform the market.
But this is true of every strategy, be it active or passive.
I’ve been on a podcast tour the past couple of months for my new book. I’ve gotten a lot of questions about the different ways in which you can now diversify a portfolio:
Is the 60/40 portfolio dead? Don’t we need to update this with the times?
What do you think about adding gold to a portfolio? Or Bitcoin?
How about trend-following or managed futures?
How should investors think about diversifying their fixed income exposure given the bond bear market this decade?
How about buffer ETFs? Or option income funds?
What about private investments?
The good news is there has never been a better time to be an individual investor in terms of the investment opportunities available to you for diversification purposes.
The bad news is there has never been more temptation to change your portfolio and overdo it by diworsifying your portfolio with too many funds and strategies.
There are no right or wrong answers when it comes to diversification and asset allocation.
Some investors need to keep things super simple in a 3-fund portfolio. Some people prefer a single fund. Anything more complex than that and they get overwhelmed.
Other investors prefer to have more bases covered from a diversification perspective and hold all kinds of different funds and strategies in their portfolios.
There is no one perfect portfolio for every investor but I do have a rule that can help you understand if the asset classes, strategies and holdings in your portfolio are right for you.
I call it the diversification test.
It goes like this: If your investment is down in value will you lean into the pain and buy more?
Far too many of the institutional investors I worked with would do the opposite. Every time a manager underperformed, they hit the eject button and fired them.
One of the reasons for this is because many of the managers had more discretionary and complicated strategies. It’s much easier to stick with a strategy when you understand it.
This is one of the reasons I’m such a big believer in rules-based strategies and index funds. With a discretionary manager, it’s hard to know if you’re being disciplined to a process that’s out of favor or oblivious to the fact that it doesn’t work anymore.
I’m more confident leaning into the pain when a rules-based strategy goes through a dry spell. Nothing is guaranteed in the markets but if you know what you own and why you own it, you can set more reasonable expectations and have more confidence in your process. That way you’re not constantly tempted to jump in and out of different investments all the time.
It’s easy to invest in something when it’s going up.
The true test of any investment strategy or allocation is how you handle it when it’s falling behind.
Further Reading:
Creating the Perfect Portfolio
