There Is No Perfect Portfolio
- Aug 23, 2016
- 4 min read
Humans are perfectionists. We are constantly striving to introduce new efficiencies in our lives. Just look at all the apps available in the App Store. Consider the app iPhone Blower, where the phone blows out your birthday candles for you. Because, you know, who wants to be bothered???
Let's chalk that app up to "extreme novelty". It's really not more efficient or superior to simply taking a deep breath and blowing candles out like a normal person. Like all frivolous apps, I see a lot of similar gimmicky / novelty / unnecessary tactics when attempting to achieve superior investment returns.
This gimmickry is often driven by the misconception that one Asset Allocation is inherently superior to another. If a universal "best" portfolio actually existed, there would be no investment advisors. There would only be financial planners and robots to help investors pick funds (the latter already exist).
Small Differences
Whether you allocate 25% or 30% to international stocks, 4% or 7% emerging markets, or 12% mid cap versus 15% doesn't add up to a drastically different portfolio. These minor differences in allocations aren't big enough to drive your portfolio return much higher or lower. I doubt you'd even notice.
It's unnecessary and largely ineffective to labor over such decisions. To really feel the impact of a particular slice of your portfolio, you need to be closer to a 10% representation.
The Word "Optimal" Can Be Misleading
The Efficient Frontier is the most optimal set of portfolios at any given point in time. The best investment managers use long term historical data to build and maintain their portfolios, getting as close to this line as possible*.
Chart Source: American Association of Individual Investors, The Benefits of Modern Portfolio Theory, Rotblut, June 2010.
Theoretically, what is most efficient changes throughout each trading day. Because market forces are constantly changing, it's wrong to say "this portfolio is optimal".
It's better to say "historically, this portfolio is closer to optimal, on average, a greater percent of the time". We should also say our data is from the past, and in the future things may or may not be different.
Shiny New Strategies
It's easy to get caught up in the idea that you need to adjust things, at least that's what fund companies spoon feed advisors who vomit it all back up over investors. No, you don't need to be messing around all the time. By the time you think you need to do something, 4 million other investors have already beat you to it, and you'll probably end up on the losing side of the trade.
Since the invention of the stock market, investors have received a barrage from financial experts suggesting they're doing it all wrong. They do this by pointing to something in your portfolio, cherry picking a time frame that part of your portfolio underperformed, and then yelling SEE??? I recommend NOT doing that, blah blah blah...
Brilliant...
Actual Investor Returns
When market returns aren't favorable, impatience can be an investor's worst enemy. Losing sight of the long game compels many investors to alter their strategies, which has been proven to contribute to lower returns. For whatever reason, they decide this is the day they no longer belong in insert fund name here. Unknowingly and often repetitively, these investors usually blow it because the market rewards time in the market more than market timing.
They even measure how bad investors blow it according to fund flows (both in and out). Here's how bad that second guessing has burned individual investors**.
According to Dalbar's Quantitative Analysis of Investor Behavior, "Analysis of the underperformance shows that investor behavior is the number one cause, with fees being second"**. My favorite quote comes halfway through Dalbar's report:
Investor behavior is not simply buying and selling at the wrong time, it is the psychological traps, triggers, and misconceptions that cause investors to act irrationally. That irrationality leads to buying and selling at the wrong time which leads to underperformance.
Let Reality Sink In
Let's assume you don't own a completely bone head portfolio; you hold adequate percentages of the basics such as large / mid / small cap, a healthy dose of international including emerging markets, and enough short & intermediate bonds to dilute the risk of stocks (as appropriate for your capacity for risk & time frame).
What I just described is a globally diversified portfolio. The idea behind this design is a balance between the highest expected return and the least amount of volatility, i.e., palatable to the majority of investors.
What you should expect is different parts of the portfolio can (and should) yield different results over various time frames. Take the last 24 months for example.
S&P 500, 14.5%, Bonds, 8.0%, International Stocks, -4.8%, Emerging Market Stocks, -10.7%
At any given time, there are probably parts of your portfolio that make you want to break things. When you feel the urge to channel your inner hulk, try to remember your portfolio is the sum of its investment parts, and it's the collective return that matters most.
When funds (or Individual Stocks, Cringe...) are down or staying down, I often give clients a tough dose of reality. "Are you planning to spend 100% of your investment dollars tomorrow, next year, in 5 years, 10 years?". I'm sure there are exceptions out there, but so far no one I've asked has ever said yes.
Once they realize my point is yesterday's investment strategy is still valid today, they back away from a potentially dumb move (unlike all the poor folks from the Dalbar report). They acknowledge and accept that volatility and risk go hand in hand, and this is the best way to achieve their long term goals. And last, they recognize that there is no perfect portfolio.
* American Association of Individual Investors, The Benefits of Modern Portfolio Theory, Rotblut, June 2010.
** Dalbar's 22nd Annual Quantitative Analysis of Investor Behavior, 2016 (for the period ending 12/31/2015).
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