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Tinkering and Chasing Performance

Passive investors aren’t immune to the temptation to chase performance. We just do it by tinkering with our asset allocations rather than hopping between various actively managed funds.

For Example

Imagine two portfolios: Both have a 70/30 stock/bond split. Both have the same total costs. And both have identical holdings in the bond portion of the portfolio. The difference is that:

Theoretically, Portfolio B should earn slightly higher long-term returns than Portfolio A because it carries slightly higher risk. Of course, there’s no guarantee those additional returns will materialize over any particular period.

All we know with certainty is that there will be some years in which Portfolio A does better and some years in which Portfolio B does better. And that can create a temptation to tinker: “Perhaps I should be overweighting small-cap and value stocks after all.” or “Perhaps I went a little overboard with the small-cap/value idea.”

However, picking either A or B and sticking with it is likely to beat the heck out of jumping back and forth between A and B, always moving to the one that’s done well over the last couple years.

Be Wary of Tinkering

The same thing happens with your allocation to REITs. Whether you allocate 5%, 10%, or 20% of your portfolio to REITs, there will always be years in which you wish your allocation was something different from what it is.

And with your U.S. vs. international allocation: Should 20% of your stock portfolio be invested internationally? 40%? Regardless of what you choose, there will always be some other allocation that’s done better.

Be wary of the temptation to tinker with your portfolio. It may be nothing other than chasing performance.

Or to put it differently: How we invest is at least as important as what we invest in.

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Comments

  1. Mike,

    I understand where you’re coming from, and I can’t deny I’ve felt the same temptation. But in my case at least (and I do tend to leave things alone for the most part) I feel it’s less a matter of chasing performance than of not knowing what to believe from all the conflicting advice out there. For instance, if you look at Coffeehouse Investor, he favors a domestic allocation divided 25% each from large and small caps, blend and value. But if you try out such a portfolio at Vanguard, you get a caution message like this:

    “Your portfolio emphasizes value stocks, which puts you at risk of underperforming the market when growth stocks perform well… A blend style offers a mix of value and growth investing. We believe that your portfolio should be style-neutral, not biased toward either growth or value stocks.”

    These are two reputable sources both endorsing the Boglehead approach. So who do I believe? I’m looking not the find the strategy that’s worked best for the past “couple of years,” but the one that works best on a permanent basis.

  2. @ Larry – I agree. This is why I invest in a target retirement fund. It’s the one strategy where I have little chance of screwing it up myself.

  3. Larry,

    I don’t think there is a permanent “best” portfolio. It will depend on the particular time period you are invested. However, you could have a portfolio with both growth funds and value funds and rebalance between them that would remove the guesswork.

    -Rick

  4. @ Rick Francis: “I don’t think there is a permanent ‘best’ portfolio.”

    Perhaps there is not. What gets confusing is when one supposedly reliable source recommends something another source is dead set against. That, more even than volatility, is what I find unnerving.

  5. Larry: I agree. It can be tricky to figure out how to allocate your investments when you get differing opinions from people you trust.

    To me, that’s why it’s so important to actually understand why you’re investing the way you are. To use your example, if you decide to tilt toward small-cap/value, it’s essential that you understand what goal that’s intended to achieve, why it is supposed to achieve that goal, and what you lose if it doesn’t achieve that goal.

    If the only reason is “because Bill Schultheis said so,” then you’re likely to bail at exactly the wrong time. That is, you’re likely to end up chasing performance. 🙂

  6. Agreed. That’s the problem. No doubt there are pros and cons to the Coffeehouse and other approaches I need to understand better. When I started with Vanguard back in 2003, a very experienced friend sent me an extensive set of articles and we worked out several sample portfolios. I did eventually go with a portfolio that had a “tilt” towards small caps and value.

  7. Chasing performance is a bad strategy, but what about adding the value / small cap stocks, and then rebalancing annually to put money into the poor performers?

    It doesn’t get away from the risk of underperforming, of course, but it does away with the chasing winners risk.

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