The risks of performance chasing.

FINANCIAL PLANNING MAGAZINE has an interesting article on performance chasing.

One of the unfortunate habits of some investors is regret over not having invested in some hot stock, or hot fund.

Assuming a person could accurately pick each year’s winning asset class at the start of each year, and devote an entire portfolio to that asset class, that investor’s 15-year annualized return would have been an astounding 32.25{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}, with a standard deviation of annual returns of just under 19{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}.
By comparison, an investor who simply hunkered down in the S&P 500 for the entire 15-year period experienced an annualized return of 4.39{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} and a standard deviation of 19.1{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}.

As a result of this tendency some people will invest their entire portfolio in the previous year’s best-performing asset class.  By buying last year’s winning asset class:

…  the 15-year return plunged to 2.71{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} for an investor using this strategy during the 15-year period, while the standard deviation of annual returns increased to 23.7{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}.

So how would the investor who prudently created a well diversified portfolio fare?

The ending outcome of simply investing in all 12 asset classes each year (and then rebalancing at year’s end back to equal allocations) resulted in a 15-year annualized return of 7.95{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} and a standard deviation of 12.8{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} – far better than what the S&P 500 by itself generated.

Of course that diversified portfolio can’t match the “perfect” portfolio, but our crystal ball is broken, so we’ll settle for the “good” rather than the “perfect.”


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