When Should I Worry About Performance?

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The short-term performance of one or more asset classes is a primary reason why some people abandon their investment strategy, but it is not normally a very good reason.

The markets are inherently volatile but also inherently profitable. When you start investing in the markets, you are very likely to see many highs and lows as the market gyrates before you see permanent gains.

If having an advisor allows you to sit tight during market downturns, it is money well spent. If your advisor is rebalancing your portfolio while you are gardening, it is even better.

Although most of the time you do not need to worry about performance, some performance is cause for concern. You need to have the long-term perspective to be able to tell which is which.

Here are 5 times you should not worry and 4 cases when you should.

5 Times You Should Not Worry About Short-Term Performance

1. You have the emotional urge to “do something” generically.

Our brains are wired to want to do something when we are upset. In investing, it is usually better to do nothing. The markets gyrate up and down. If you have the urge to do something because of performance numbers but don’t have any more specifics, you are probably better off doing nothing.

James B. Cloonan the founder and chairman of the American Associate of Indivdiual Investors (AAII) says it well, “Real risk is the likelihood of not having the assets saved when you need them. Phantom risk is volatility that has little impact on the long-term investor.” The returns of the markets are like a whip being cracked up and down by someone riding an escalator. You’ll get dizzy tracking the tip of the whip, but if you take a long-term perspective and watch the escalator, you’ll be able to relax and enjoy the ride.

2. Your bond allocation is underperforming various indexes.

People who are taking regular withdrawals from their portfolio should have an allocation to short-term bonds. The shorter term bonds will have a lower average return than the bond index, which includes higher risk bonds, and a much lower return than stock investments, which are riskier still. However, if you have withdrawals, you benefit from having those bonds in your portfolio. Having everything in stocks risks withdrawing early in the sequence after poor returns and therefore not having enough money remaining to grow when the markets recover. (See “Your Asset Allocation Should Be Priceless” for the math on this.)

3. You want more of a sector that has done well or less of a sector that has done poorly.

When a category has underperformed, it is more likely to have a better return going forward. Moving out of categories that are down and into categories that are up is called chasing returns. Rebalancing boosts returns, but chasing returns is the opposite of rebalancing. Chasing returns is one of the primary causes of underperformance. Investors underperform the very mutual funds they are invested in because they buy funds after they have gone up and sell funds after they have gone down.

4. Everything was up except for the thing you want to get out of your portfolio.

A category may underperform during otherwise up market movements because it has a low correlation to the market index you are measuring it against. For example, resource stock categories, such as energy and real estate, have low correlation to the S&P 500 and are often negatively correlated to bonds.

This lack of correlation is what makes them a good portfolio component but also what makes them prone to be down while everything else is up. In practice, low-correlation portfolios are like bitter vegetables: they are good for you but not always fun to have.

5. One fund is really volatile.

An uncorrelated category can reduce the volatility of your portfolio even if that category by itself is very volatile. In our article “Why Invest In Chile?,” we showed how a small allocation to a category that cracks up and down wildly can still reduce the volatility of the portfolio as a whole while pulling up returns.

4 Cases When You Should Make a Change

Finally, here are 4 reasons that you should worry about a component. You should be worried when:

1. There are similar lower cost funds.

If a security’s expense ratio is too high, you may have selected a non-ideal security. Even if the component has done well, you should explore less expensive fund options. There may exist a lower cost fund that represents the same category and would have performed even better. In general, we consider any expense ratio over 0.50% too expensive. We think that optimum portfolios can be built with average expense ratios of 0.24% or lower.

2. You are not invested on the efficient frontier.

The efficient frontier is comprised of portfolios which represent the highest return you could expect for a given amount of risk based on long term analysis.

Some investment categories produce higher returns or lower volatility when you add them to a portfolio. These categories are the building blocks of a portfolio near the efficient frontier. Other investments add volatility or decrease returns when they are added. These are drags to portfolios they are a part of and move portfolios away from the efficient frontier.

The only way to bring your portfolio consistently closer to the efficient frontier is to understand the factors which produce a higher mean return and lower volatility. For example, the correlation between categories is important.

3. You need to rebalance.

If an investment category has recently appreciated significantly, then you might find yourself out of balance from your asset allocation. Categories should be regularly trimmed and rebalanced back to their target asset allocation. If you do not rebalance, you may find yourself accidentally overweighting one category and no longer following your investment strategy.

4. Everyone is talking about your investment.

My father often said that you knew a category was dangerous when your hairdresser or taxi cab driver was talking about. The crowd is usually wrong. He also said you could probably safely short any company whose CEO was on the cover of Time magazine or whose firm was building a new corporate headquarters.

Photo by Jordan Whitt on Unsplash

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)

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