The books will close on 2021 in just a few days, and the headlines will show that it was a solid year for the stock market. However, underneath the surface the second half of the year has been very bumpy and performance gaps inside of diversified portfolios are quite wide. The S&P 500, for instance, is up 20% year-to-date. But a “total market” ETF like VT, which includes non-US stocks is up a little less than 13%. During the second half of the year, the S&P 500 is up 5.50%, but VT is flat. For diversified portfolios like the ones we manage, VT is a much better benchmark than the S&P 500.
The challenge for disciplined investors
The challenge for disciplined investors is to stay true to their diversification tenants. Inside of our portfolios, we have exposure in many areas of the “total market:” S&P 500, small cap stocks, European stocks, Chinese stocks, etc. So while our S&P 500 exposure is performing well, other areas like small cap stocks, or emerging market stocks, are down 4% and 11%, respectively, since July 1st.
Performance spreads are not unusual, in fact they are to be expected, but the scope of them this year has been wider than historical averages. In markets like these people may wonder, “Why own anything but the S&P 500 if it’s performing the best?” The problem with this question is twofold:
- It assumes that past performance holds some predictive value towards future performance
- It establishes a precedent of performance chasing (buying whatever is going up and selling whatever is going down)
Dimensional Fund Advisors (DFA) and Vanguard have published numerous academic studies over the years that address our first point, and the research is clear: past performance has very little predictive value in forecasting future returns. A 2018 DFA study found that the vast majority of top performing mutual funds did not remain top performers over the next five years. In effect, one of the best ways to increase your odds of underperforming in the years ahead is to buy what ever has out performed in the years past.
In regards to our second point, performance chasing is akin to heroin for a drug addict. Once you start doing it, it’s hard to stop. And as we explained in the previous paragraph, it can have terrible effects on your investments. The simple truth with investing is that some investment will almost always be performing better than the one(s) you own. So if owning whatever is performing best is your strategy you will never actually own what is performing best, you will own what was performing best. Why won’t that work? See our first point.
Sticking with diversification
Sticking with diversification does not come without its own challenges. Psychologically, it can be hard to “sell winners for losers.” But that’s exactly what must be done in diversified portfolios right now. Recently, we’ve been selling some of our S&P 500 exposure and adding to our exposure in small-cap and emerging market stocks. Note that this isn’t a result of changes in our models, but natural changes in our portfolio weights due to the performance spreads referenced earlier.
For example, in a $100,000 equity portfolio we may have the following allocation targets:
|Large Cap (S&P 500)||42.00%||$42,000.00|
|Mid Cap (Mid-cap 400)||16.00%||$16,000.00|
|Small Cap (S&P 600)||16.00%||$16,000.00|
But due to varying performance so far this quarter, the current portfolio may now look like this:
|Category||Target||Starting Value||Q4 Return||Gain/Loss||Current Value||Targeted Value||Difference|
|Large Cap (S&P 500)||42.00%||$42,000.00||5.84%||$2,452.80||$44,452.80||$42,776.33||-$1,676.47|
|Mid Cap (Mid-cap 400)||16.00%||$16,000.00||0.96%||$153.60||$16,153.60||$16,295.74||$142.14|
|Small Cap (S&P 600)||16.00%||$16,000.00||-1.30%||-$208.00||$15,792.00||$16,295.74||$503.74|
In order to get back to our targeted 42% exposure to the S&P 500, we need to sell $1,676 worth of that exposure. To get back to our 16% target for small cap stocks, we need to buy $503 worth of that exposure, and so on and so forth. This type of diversified portfolio model is not complicated by any means, but it does require discipline. We must be disciplined enough to sell some of what is performing best and buy more of what is performing the worst.
It can be easy to question the benefits of diversification in a market like this. After all, when the market drops, you still participate in some losses. And when the market rises, you only own some of what is performing best. However, a diversified portfolio will typically outperform an index like the S&P 500 over longer periods of time. Here’s a great graphic to help illustrate the irony of diversified portfolios:
So no matter what, stay disciplined in your approach to investing!