When Is It Better To Underperform The Market?

When Is It Better To Underperform The Market?

That doesn’t sound right, does it? Who would ever want to underperform the stock market? Shouldn’t the goal be to consistently beat the market? That would be great, but how easy is it to do?

S&P Global produces an annual report called SPIVA (https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-mid-year-2023.pdf) which compares how actively managed funds – those that attempt to beat an index – have performed against their benchmark indices. Page 9 of the most recent report lists the percentage of funds which underperformed their respective benchmarks over the short-term and the long-term. Take the large cap stock asset class, for example.  Over the previous 12 months, 51% of all funds underperformed the S&P 500. Said another way, only 49% beat the market. That’s actually pretty good when compared to longer time frames. Over the past five years, less than 14% beat the S&P 500. And that number drops significantly lower for longer periods of time. Not only that, it’s rarely the same funds that can outperform across different time periods. Try finding in advance that one-in-a-thousand fund (if any) that can consistently provide you with superior returns.

So assuming that you can’t outperform the stock market all of the time, do you have any choice as to when you can do it? The answer is a qualified “yes.” Although you can’t directly control returns from any individual investment, you can indirectly influence your portfolio’s returns through the allocation model you choose. That is, how much of your portfolio you allocate to stocks, bonds, cash, real estate, commodities, and any other asset classes you use for diversification. Historical data tells us that the equity asset class has among the greatest long-term returns, but along with that it also carries the highest volatility. Which means that during periods when stocks are rising, they will likely provide the highest returns among all asset classes, but when they are falling, they are likely to be one of the worst performers.

That brings us back to the original question: when might be the best time to underperform the stock market: when it’s rising or when it’s falling? Behavioral psychologists Danny Kahneman and Amos Tversky developed Prospect Theory in 1979. Among other things, they learned that the pain of losing is psychologically more powerful than the pleasure of winning. With respect to the stock market, that means most people would be willing to trade off higher gains when the market is rising if that means avoiding greater losses when the market drops.

The good news is that portfolio diversification is designed to do exactly that: by investing in different asset classes you reduce overall portfolio volatility. With proper diversification, you will likely underperform the market when stocks are rising. But during market declines you are likely to lose less. And the lower volatility has a side benefit which I will explore in a future column.

If you are an individual with a high tolerance for risk, you might prefer to swing for the fences in order to maximize your returns regardless of the risk. That’s fine as long as you are confident in your ability to thrive after a market plunge or other catastrophe. (After the 1932 crash, for example, the stock market did not return to its previous high until 1954). On the other hand, if you’re comfortable underperforming the market when it’s rising but not when it’s falling, there’s a simple and well-established methodology that is likely to do just what you want.

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