In 2019, the S&P 500 returned 31.49%! Performance this good is rare, the S&P 500 has only generated annual returns this high 11 out of the past 83 years. Given these spectacular returns investors should beware, the most common and often damaging investing mistake after blockbuster years like last year, is to give into the temptation to chase performance.
A traditional diversified investor with a portfolio of around 60% in stocks and 40% in bonds, most likely generated returns around half the S&P 500 in 2019. Returns of around 14% for diversified portfolios, while excellent, do not usually make investors happy compared to what the broader S&P 500 returned. 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.
This comparison can trigger investor greed as the fear of missing out on a continuation of unusually high returns drives investors to chase those potential returns by increasing their allocation to stocks. Missing out on unusually high returns, like we saw last year, can be as psychologically tormenting to investors as watching their portfolio suffer very large losses. Often the urge to chase performance hoping to earn higher returns can prove to be too much for investors leading to a cascade of mistakes.
The temptation of a diversified investor to chase performance can result in two distinct, but equally damaging investing mistakes. The first mistake is dramatically increasing the risk of a diversified portfolio by buying more stocks at already high prices, in hopes of increasing returns. Investors who make this mistake usually plan to return to a diversified strategy in the future when the stock market begins to encounter challenges and negative returns, which is the definition of 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, which is the opposite of a good investment strategy.
To succeed at a market timing strategy, an investor must be right about both the future direction of the stock market and the timing of when the stock market direction will change. They must be right about direction and timing when both 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, 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 performance or making predictions is not part of a diversified investment strategy because a high-quality 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 values over the long-term. By compounding on higher average portfolio values, it is possible to make up for not capturing all the stock market’s 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 instead 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 yourself 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 performance, consider viewing our video series called the Five Secrets to High Performance Investing. We go into detail on how reducing risk and remaining diversified makes 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.
If you would like professional assistance in evaluating your investment strategy and portfolio or making a financial plan, please call (571) 565-2161 or email us, we are always happy to help. Also, consider learning more about this topic and gaining unique investing insights by listening to our popular podcast or viewing our investing video series.