August 3, 2015
Written by Nathan Erickson, CFA®, CAIA, Chief Investment Officer
Golden Delicious, Granny Smith, Honeycrisp, McIntosh, Red Delicious, Fuji… If you were asked to compare these different types of apples and choose which apple you think is the best, you would easily be able to respond to this request. However, if you were asked to compare a Golden Delicious apple to a Navel orange and choose your favorite apple, you would probably respond with “An orange isn’t an apple, so I can’t compare them.”
While the conclusion is simple when it comes to fruit, people make the “apples to oranges” comparison too often when it comes to investing. This occurs most frequently when an investor compares his or her portfolio to a single asset class. A well-diversified portfolio contains stocks, bonds, and other asset classes, and it should not be compared to a single asset class like the S&P 500 or the Barclays Aggregate Bond Index. One is a fruit salad; the other, just a single fruit.
Why do investors have a tendency to do this? Perhaps it is because when they evaluate their portfolios, they do it in a one-dimensional way. Investors evaluate success solely on return (in percent or dollars) and compare their returns to returns they could have experienced elsewhere. In 2008, many investors looked at their returns and thought “I would have lost less money if I had only owned bonds.” In 2009, they looked at their returns and thought “I would have made more money if I had only invested in emerging markets.” As we have shown our clients many times before, chasing asset classes is speculation and that strategy does not pay off. Last year’s winner is often next year’s loser. Instead, if your time horizon is truly five to ten years or longer, building a diversified portfolio and committing to it often leads to better compound performance than many single asset classes.
So how should investors evaluate their portfolios? The first and easiest way is to look at the portfolio’s objective. For most people we serve, the first objective is to not lose what they’ve entrusted us to manage, and the second is to grow it at a rate that will meet their spending needs for as long as they need it. We would translate this as “take as little risk as possible to deliver meaningful positive returns annually over the long term.” If your portfolio is expected to achieve all of your financial objectives over time with reasonable confidence, then the portfolio is doing well.
The second way to evaluate a portfolio is to compare the component asset classes. Rather than compare your portfolio to the S&P 500, only compare the amount invested in U.S. large cap stocks to the S&P 500. Compare small cap stocks to a small cap benchmark like the Russell 2000 Index and so on throughout the portfolio. We recently rolled out a new performance report, which provides the data needed to perform this analysis. This asset class comparison allows investors to make a true “apples to apples” comparison. Keep in mind, however, that if your goal is to outperform the benchmark, the only path to achieve this is to be different than the benchmark. This difference means that at times the portfolio may underperform. The asset class comparison should be viewed over longer periods, preferably 3-5 years, allowing time for the differences to provide outperformance more frequently than underperformance.
The third way to evaluate a portfolio is from an asset allocation standpoint. If the portfolio we build is like a fruit salad with apples, oranges, pineapple, grapes, and mango, we would want to compare our portfolio to the average fruit salad. Suppose the average fruit salad has equal parts of the above listed fruits. An asset allocation analysis would look at our fruit salad’s variances (e.g., more apples than the average, less grapes than the average) and evaluate whether our decisions which created those variances were good or bad. This can be done by building a blended benchmark of the underlying broad categories and comparing the portfolio to the blended benchmark over time. For example, at Miller Russell Associates the category average we use for stocks is the Morgan Stanley Capital Indices (MSCI) All-Country World Index. This is an index of the global stock market weighted by market cap. For bonds, the category average we use is the Barclays US Aggregate Bond Index. For multi-strategy, the category average we use is the peer group of tactical allocation managers in Morningstar who have flexibility to invest in multiple asset classes. This peer group is the best comparison to the decision making that occurs within multi-strategy. The broad category benchmarks are weighted to the portfolio’s broad asset allocation, providing an “average fruit salad” return in which to compare the portfolio.
As we begin to roll out blended benchmarks in our performance reporting, our clients will be able to make a true “apples to apples” (or fruit salad to fruit salad) comparison with a single number for their portfolios and a single number for the benchmark. Once again, minor variances are to be expected, especially in the short term, but the value of the blended benchmark is that it accurately reflects the objective and characteristics of our clients’ portfolios.
“I’m Never Eating Shrimp Again”
This past week while traveling, my son and I stopped for dinner. We ordered shrimp, and as he bit into the first shrimp, he suddenly felt a pain in the side of his cheek. Somehow he had developed a small sore in his mouth which was very painful as he ate; however, he attributed the sore to the shrimp. As a result, he said he will never ever eat shrimp again due to that experience.
This may seem like a childish response, but it accurately reflects a behavioral tendency called “recency bias,” and investors frequently respond this way. They tend to extrapolate their most recent experiences into the future and assume this is what they can expect going forward. The most extreme example of this is investors who lost 20% or more of their portfolios following the financial crisis in 2008. For many, this experience was so traumatic that they took all their money out of investment markets and went to cash. Some remain in cash more than six years later because they are afraid of losing that much money again.
Most recently, diversified portfolio returns of 2-4% in 2014 and 1-2% through the first half of 2015 have some investors concerned that this is the expectation of future returns until the end of time. While we cannot predict the future, markets and to a lesser extent diversified portfolios do not travel in a straight line, nor do they maintain a constant speed. In 2014, diversified portfolios were up 6-7% through the first half of the year, only to finish the year at half that level. While returns through the first half of 2015 have been low, we may see that change in the second half of the year and be surprised with year-end results.
More importantly, investors need to remember that they are due a return for the risk they are taking. For stocks, this is called the equity risk premium, and it has been paid to investors for more than 100 years. It is typically 4-6% above the risk-free rate of return, or the return on short-term government bonds. The return on stocks also has an inflation component and a growth component. We have been talking to clients over the past several quarters about adjusting return expectations due to the low inflation and low growth environment we have been experiencing, but investors will continue to be compensated for the risks that exist. Once again, the compensation for these factors may come in fits and starts, but they have consistently been realized since the inception of investing in all asset classes.
One would never compare apples to oranges, nor would one allow the last shrimp eaten to represent all shrimp of the future. As investors, we must be conscious of our biases and we should evaluate our portfolios appropriately, against accurate benchmarks, and over longer periods of time. Not doing so can lead to “return envy” and poor decision making, which is a much greater risk to long-term success than any performance number over a 3-, 6-, 9-, or even 12-month period.
As always, we welcome your questions and comments, and we appreciate the opportunity to serve you.
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