Note: If you would prefer the audio version of Investing Insights, click here to listen to our podcast Episode 7: Chasing the Siren Song of High Returns
Last year was a great year to be invested in the U.S. Stock market, but also in pretty much any other market. International stocks, gold, bonds, you name the market and they all had a great year. But far ahead of the rest, the S&P 500 had a banner year in 2019 returning over 31%. This magnitude of performance by the S&P 500 has only happened 11 times over the last 83 years, so it is safe to say that 2019 could be considered an outlier year for market returns. While you might believe most investors would be happy with their investment returns in 2019, the truth is many are not.
After a spectacular year like last year, investing can seem easy, when in fact, market conditions like we encountered are precisely what cause investors to make some of their biggest mistakes. This is the perfect time to discuss performance chasing. I am going to explain why chasing returns is dangerous and how unusually high market returns often set investors up to make potentially damaging decisions that can lead down a path of diminishing investment success.
When the U.S. stock market delivers returns of over 30% like last year, everyone takes notice, this attention makes it much more likely for investors to make mistakes. Experience has made it easy for me to predict the investors most likely to make big mistakes during outlier years like 2019. The investors are usually either diversified portfolio investors or investors who try to time the stock market.
Let’s first look at the mistake commonly made by market timers during outlier performance years. In 2019, investors trying to time the stock market are likely to have already been on the sidelines, in cash or invested in just a lower allocation to stocks during part or most of the year. Last year, the U.S. stock market was frothy, but there were many negative leading indicators that have historically predicted significant market declines including an inverted yield curve, historically low unemployment, slowing auto sales and many more. These indicators combined with historically high U.S. stocks valuations led to uncertainty and worry among investors throughout the year and inevitably pushed many market timers out of stocks, resulting in what I am sure is great disappointment having missed out on historically high returns.
There is an old saying, “Markets climb a wall of worry”. This simply means that when traditionally negative indicators appear in the market, prices often continue to climb unfazed by the potential for bad news. It is precisely during periods of investor uncertainty that a year of unusually high returns is most likely to occur. On the other hand, and most unfortunately for market timers, large negative returns are also most likely to occur during periods of investor uncertainty. The unpredictable outcomes that accompany extreme market conditions like we saw in 2019, is the fatal flaw of market timing strategies. Simply put, stock markets are not predictable and there is no evidence I have been able to uncover to refute this observation.
Next, we can examine a common mistake made during outlier performance years by diversified investors who invest in 60/40 or similar portfolios. In 2019, a diversified investor most likely generated returns less than half the S&P 500 for the year, their returns of around 14%, while excellent, do not make them happy compared to what the broader S&P 500 returned. Despite having around 60% of the portfolio in stocks, it is not hard to figure out why a diversified portfolio returned less than half the S&P 500 last year. The reason is diversified portfolios do not only invest in U.S. stocks, but also in international stocks. International stocks dragged down performance because they did not perform as well as the S&P 500 during the year.
Despite the possible disappointment diversified investors may have felt about their returns at the end of 2019, they still had a better chance of generating higher returns than market timers. Incorrect predictions are not the cause of mistakes for diversified investors but instead the influence of behavioral biases often push diversified investors to chase performance. Following periods of abnormally high returns, investors naturally compare their portfolio to widely publicized index returns, like the S&P 500, despite the irrelevance of the comparison. Investor greed sets in and the fear of missing out on even higher future returns drives investors to chase those potential returns. Chasing returns means increasing their investment in stocks, for many investors that means going all in on stocks, while hardly considering the huge increase in risk they have assumed or more importantly, when they will decrease their risk again by reducing their stock position.
Diversified investors who shift their portfolio from a less risky and more broadly diversified portfolio, into a portfolio mostly or entirely invested in stocks completely change their investment strategy and they become market timers. When an investor shifts to a market timing strategy they now need to predict when to go back to a more fully diversified portfolio and reduce their exposure to stocks in order to avoid very large potential losses in the future. Unfortunately, the decision to reduce risk is usually made after an extended period of losses.
The temptation of a diversified investor to chase performance usually results in two distinct but equally damaging mistakes. The first mistake is to dramatically increase the risk of the diversified portfolio at already high prices, in hopes of increasing returns, therefore moving from a diversified strategy to a market timing strategy. The second mistake happens when the very risky portfolio takes large losses, which then can cause a panic, pushing the investor to reduce their allocation to stocks at lower prices in order to de-risk the portfolio to slow or stop losses. What should be clear from this all too common scenario is that the urge to chase performance pushes investors to change investment strategies and become market timers, sadly, market timing almost always results in buying high and selling low.
To successfully time the stock market, an investor must be right about both the future direction of the market and the timing of when the market direction will change. They must be right about both direction and timing when increasing and decreasing their allocation to stocks. If you are counting, market timing success requires four correct predictions in a row! If you can flip a coin and get heads every time you flip the coin, regardless of the number tosses, you are destined to be a great market timer and should stick with a market timing strategy. For the less lucky among us, we are forced to come up with a more sophisticated investment strategy that both maximizes the probability of investing success and eliminates the need to depend on predictive powers.
The solution to avoiding costly investing mistakes during extreme markets is to do nothing at all and instead remain invested in a well-designed, low-risk, diversified portfolio. Chasing returns or making predictions is not part of a diversified investment strategy because a diversified portfolio does not need to capture all the positive returns the market produces, it must simply limit how much of the negative returns it captures. The success of a diversified portfolio comes from relying on the power of long-term averages.
Reducing the size of a portfolio’s average investment loss allows the portfolio to benefit from compounding on higher average portfolio values over the long-term. By compounding on higher average portfolio values, it is possible to make up for not capturing all the markets positive returns over time. The best part of a diversified strategy is that your success does not depend on your predictive abilities but instead on your ability to be patient while maintaining a long-term outlook. The best investment strategy is to resist the siren song of capturing 100% of market returns and focus on capturing much less than 100% of market losses. You should rely on the power of long-term averages and compounding to build your wealth more consistently over the long-term, thus giving you the highest probability of achieving your investment objectives.
To better understand how the math and strategy behind a low-risk, diversified portfolios works, and why they are the best alternative to chasing returns, consider viewing our video series called the Five Secrets to High Performance Investing. We go into detail on how reducing risk and remaining diversified make it possible to generate much higher levels of wealth than taking on too much risk or trying to do the impossible and time stock market movements.
Additional Resources
We have released a great video series where we share our investing secrets.
Click here to view our video series – The Five Secrets of High Performance Investing
Investing Insights: Diversified Portfolios – The Common Source of Investor Displeasure
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