A central tenet of our investment philosophy is diversification. Furthermore, we advocate for “real diversification”, which means owning thousands of stocks in companies of all sizes (large and small), geography (U.S. and non-US) and investment style (value and growth). This type of diversification represents the only “free-lunch” there is in investing.
But real diversification also introduces a concept known as “tracking error regret”. Tracking error regret is the risk that an investor will regret holding a diversified portfolio when that portfolio underperforms a popular benchmark such as the S&P 500 (a benchmark for U.S. large-company stocks). While tracking error regret is purely a psychological risk, it can have a real impact on the quality of our investment experience if not properly understood.
So how should we think about tracking error regret? Here are a few ideas:
- Realize that tracking error goes both ways. Since 2008, U.S. stocks have significantly outperformed international stocks, and this has tested the resolve of many investors who hold globally diversified portfolios. But for the five years prior to 2008, U.S. stocks had dramatically underperformed non-US stocks. In other words, tracking error works both ways, at times producing underperformance relative to a popular benchmark, while at other times showing outperformance.
- Don’t fall victim to “Recency Bias”. Tracking error regret is closely connected to the recency effect, a cognitive bias which suggests that our perceptions are more heavily influenced by more current observations and experiences. In investing, this means that we tend to extrapolate recent performance into the future, tempting us to buy more of what has done well lately while selling the investments that have lagged. This strategy of buying high and selling low usually proves to be a losing strategy. To avoid this trap, we instead use a disciplined rebalancing strategy that requires us to systematically sell some of what has performed well and buy more of what has performed relatively poorly.
- Understand the difference between a strategy and an outcome. At any given moment, we don’t know what the future holds, so we must evaluate our investment decisions based on the soundness of the strategy at the time, not the known outcome after the fact. For example, if someone were to bet their life savings on the spin of a roulette wheel, and win, it was still a bad decision to have made that bet in the first place. Diversifying globally is a strategy that has theory and evidence behind it, and is, therefore, a sound investment strategy at all times.
- Be patient! As owners of a diversified portfolio, we should recognize that there will be long periods of underperformance in parts of our portfolio. But we should also recognize that these cycles can reverse quickly. For example, growth stocks outperformed value stocks by 2.1% annually for the decade ending October 2000. Then suddenly, value stocks outperformed growth stocks by 35% over the next five months!
Tracking error regret may be psychological, but that doesn’t make it any less real. After all, investing is largely a behavioral endeavor. But by understanding tracking error regret, we can recognize it when it presents itself and then stays committed to an investment strategy that puts the odds of success firmly in our favor.