2014 pitted our desire for performance against our commitment to process.
Before we ask questions about portfolio performance, we must remind ourselves that while the past is (at least) partially knowable, futures are ALWAYS unknown. The fact of the unknowability of the future informs our investment process and keeps us humble.
In 2014, the most watched benchmark in the United States (The S&P 500) gave us an above average return number, while the rest of the developed market and the emerging markets offered up negative numbers for the year. This was NOT foreseeable and could easily have been another way. To say otherwise is to engage in the fantasy of hindsight bias.
NEVER confuse good portfolio outcomes with good portfolio process. If, in 2014, you received a return number north of say 7% or 8%, then you had a great outcome because you probably had a large or very large exposure to S&P 500 companies (relative to the global opportunity set). I hope you understand the risk you are taking, though history says this is not the case. Yes – this large company U.S. focus paid off this time, but it was additional, unnecessary risk. The process employed was neither predictable nor repeatable.
You got lucky. You may get lucky again, but I wouldn’t recommend building a financial plan on top of a string of lucky market exposures. A comprehensive, lifetime financial plan (one where we are lining up inflows and outflows with current needs and future desires and one where we are making educated trade-offs and assumptions) demands a repeatable process and more predictable outcomes from our funding mechanism (your investment portfolio).
A time-tested portfolio process starts with these behaviors:
- Asset Allocation – setting a risk level appropriate for YOUR plan.
- Broad Diversification – never relying on a single market to provide the returns your plan requires.
- Rebalancing – trading some of those portfolio bits that have done well for those that have done poorly in anticipation of future volatility and “reversion to the mean.”
When appropriately tied to a well-considered financial plan, these behaviors have the highest probability of bringing that plan into reality. There is no guarantee of financial success either way, but choosing process over luck certainly improves your chances.
Unfortunately, there is still a simple downside. In a year like 2014 where the S&P 500 does well and nothing much else does, your diversified investment exposures will underperform. The “cost” of diversification is ALWAYS underperforming the top performing market.
It is important to remember that this underperformance is BY DESIGN. The only way to achieve the long-term outcomes we want is to maintain the patience and plan-based discipline in the short-term.
Please watch the video clip from our 2015 Forecasts: Past and Present event: