Don't Over-Drive the Car

Something odd tends to happen on the race track when a driver pushes harder and harder to go faster; they eventually find themselves going slower despite the extra effort. In daily life, we’ve probably all been caught out by trying to get into the “fast lane” when sitting in traffic just to see brake lights show up in the new lane while the one we just left starts moving. We then change back only to see the situation reverse on us yet again. For investors, migrating from asset class to asset class in an effort to improve performance can often be met with the same frustration.

Going back to our race track example, by over-driving the car you put more stress on the tires, therefore overheating and wearing them out faster. At the same time the driver’s interactions with the various inputs to the car, like the steering wheel and brake/gas pedals, become faster and choppier, which upsets to the balance of the car. Add in the extra stress their brains are under from focusing on going faster rather than the big picture and it becomes easy to understand why their lap times are going up rather than down. Instead, focusing on the fundamental aspects of driving, from the way you handle your steering, brake and gas inputs to the line you’re taking through the corner, is where the most lap time is to be found.

For the traffic example, it’s impossible to properly judge which lane will end up getting you to your destination the fastest because you can’t see far enough down the line of cars to make an accurate prediction. Further complicating things is the fact that you aren’t the only one trying to pick the fastest lane. If you’re seeing an opportunity one lane over, odds are that the other drivers that are looking to get ahead see it too. If enough drivers make the same lane change it will clog up the once promising opportunity, while leaving space in the now vacated lane allowing traffic to start moving there. In many cases you would have been better off staying put.

The same is true when it comes to proper portfolio diversification. Investors often try too hard to outperform the market by jumping out of one asset class and in to the another, often chasing the performance of what’s been recently doing well. Just like traffic, however, it’s impossible to know if that outperformance will persist, or if the underperformers you just left will finally turn around and become the new hot investment. Take a look at the chart below:

Source: Barclays, Bloomberg, FactSet, MSCI, NAREIT, Russell, Standard & Poor’s, J.P. Morgan Asset Management. Large cap: S&P 500, Small cap: Russell 2000, EM Equity: MSCI EME, DM Equity: MSCI EAFE, Comdty: Bloomberg Commodity Index, High Yield: Bloomberg Barclays Global HY Index, Fixed Income: Bloomberg Barclays US Aggregate, REITs: NAREIT Equity REIT Index. The “Asset Allocation” portfolio assumes the following weights: 25% in the S&P 500, 10% in the Russell 2000, 15% in the MSCI EAFE, 5% in the MSCI EME, 25% in the Bloomberg Barclays US Aggregate, 5% in the Bloomberg Barclays 1-3m Treasury, 5% in the Bloomberg Barclays Global High Yield Index, 5% in the Bloomberg Commodity Index and 5% in the NAREIT Equity REIT Index. Balanced portfolio assumes annual rebalancing. Annualized (Ann.) return and volatility (Vol.) represents period of 12/31/02 – 12/31/17. Please see disclosure page at end for index definitions. All data represents total return for stated period. Past performance is not indicative of future returns. Guide to the Markets – U.S. Data are as of September 30, 2018.

This crazy hodge podge of color is called a quilt chart and is put together by our friends at JP Morgan Asset Management. Each colored box represents a different asset class, all of which are then ordered vertically based on calendar year performance for the given year (each column represents a calendar year). The take away here is how complicated the chart is. What was at the top one year can often be found towards the bottom in later years and vice versa. Therefore, picking the best and avoiding the worst is very challenging, if not impossible, just like choosing the right lane.

In most cases, you’re better off owning all of them to some degree, with the amount of each based on your applicable time horizon and risk profile. Think of this diversified, risk based strategy as your driving fundamentals, which you should first focus on perfecting to go faster. Once the baseline strategy is optimized, making small tactical shifts between asset classes, like the driver that is adapting their driving style to changing road or traffic conditions, can add value so long as a data driven analysis is driving the shifts. Without that defined process, shifts that are meant to get you out of a traffic jam could end up leading you into a crash.