The Disciplined Investor’s Worst Enemy: Tracking Error
Last year was a tough one for disciplined investors. Disciplined investors know that diversification is a key element of successful portfolio management. But investors who stayed the course and remained diversified were punished for it in 2014, at least in the short term.
Disciplined investors will continue to be taunted over the coming weeks and months by headlines touting the success of “the market” in 2014. “Which market is that?” many of them will ask.
Well, “the market” we hear about most often is the Dow Jones Industrial Average, which represents only 30 of the largest U.S. companies trading on the New York Stock Exchange. A slightly broader barometer of “the market” is the S&P 500 index, a benchmark tracking 500 of the largest U.S. stocks. In this case, “the market” could more accurately be translated as “the U.S. large-cap stock market.”
That market—the S&P 500—did well in 2014. After a volatile autumn, the index rallied to ultimately boast a 13.68% rate of return for the year. But here’s where disciplined investors begin to cringe, because they didn’t own just large U.S. stocks. They diversified their equity exposure into small company and international stocks as well. Disciplined investors may even have expected small company and international equities to outperform a rising U.S. market.
It was not to be in 2014. Small company stocks, as tracked by the Russell 2000 index, were up a comparatively paltry 4.89%. International stocks were not up at all. Instead, disciplined investors saw foreign companies, as tracked by the MSCI EAFE index, hit by a 4.20% loss.
The technical term for the difference between what an investor expects to make, as informed by an appropriate benchmark, and what the investor’s portfolio returns in reality is “tracking error.”
But here’s my unofficial definition for tracking error: It’s the empty feeling in your gut screaming that you missed out on something which was yours to be had.
It’s the feeling a disciplined investor has when, after raising fist in victory while listening to an ebullient market update on the radio in late December, she later sees that the statements from her own diversified portfolio tell a less joyful story.
“If only I had just put everything in the S&P 500 index fund, I would’ve done so much better,” she might reason. It’s an enticing thought.
But then the disciplined investor remembers that there’s a reason she diversified her portfolio in the first place. It’s because the evidence shows that small company stocks, while less predictable in the short-term, have predictably outperformed large company stocks. She recalls that she owns international stocks precisely because they act differently than domestic stocks, a feature that has actually reduced her portfolio’s volatility over time. And
She remembers the colorful “asset class quilt,” which in a single glance can make it abundantly clear that neither she—nor the silver-tongued soothsayers on television—can persistently pick the next winner.
She resolves that she doesn’t actually have to worry about annual market anomalies because she’s investing for the long-term. She—and hopefully you— isn’t a gambler, but a disciplined investor.
This commentary originally appeared January 9 on Forbes.com
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