Tracking Error is a Feature, Not a Bug

The benefits of diversification are well known. In fact, it’s been called the only free lunch in investing. Investors who seek to benefit from diversification of the sources of risk and return of their portfolios must accept that adding unique sources of risk means that their portfolio will inevitably experience what is called tracking error—a financial term used as a measure of the performance of a portfolio relative to the performance of a benchmark, such as the S&P 500.

It’s my experience that investors don’t mind when their portfolio experiences a positive tracking error (their portfolio outperforms the benchmark). Still, they tend to get upset when they experience negative tracking errors (their portfolio underperforms the benchmark). But should that be the case? To answer that question, we need to begin by establishing what should be core investment principles.

Core Principles 

When building a portfolio, investors should adopt the following core principles. First, because the evidence demonstrates that markets are highly efficient, investors should avoid active strategies. Instead, they should use only strategies (such as, but not limited to, index funds) that are systematic, transparent, and replicable. Second, if markets are efficient, one should also believe that all unique sources of risk have similar risk-adjusted returns. Not similar returns, but similar risk-adjusted returns. If this was not the case, funds would flow to the sources of risks with higher risk-adjusted returns until an equilibrium was reached. Third, If all unique sources of risk have similar risk-adjusted returns, portfolios should be diversified across as many unique/independent sources of risk and return as you can identify that meet the criteria of persistence, pervasiveness, robustness to various definitions, implementability (meaning survives transaction costs) and have intuitive risk- or behavioral-based explanations that provide reasons for believing that the premium should persist in the future—criteria that were described in Your Complete Guide to Factor-Based Investing. I prefer risk-based explanations because they cannot be arbitraged away, though premiums can shrink or grow depending on cash flows.

Among the unique sources of risk that investors can consider adding to a portfolio are value stocks, small stocks, international stocks, real estate, private credit, long-short factor strategies, momentum, and reinsurance.  

For investors who wish to obtain the diversification benefits of adding unique sources of risk to their portfolio, the problem called “tracking error regret” raises its ugly head and leads to the abandonment of even a well-thought-out plan. The reason is that, by definition, a portfolio that is more diversified than a broad market index will experience tracking error; the very purpose of adding those unique sources of risk was for the investor to avoid having all their eggs in one risk basket. Investors diversify because they know that all risk assets experience very long periods of underperformance and there are no crystal balls that will protect you from such events. In other words, diversification is like portfolio “insurance” against having all your risk eggs in the wrong risk basket.

It’s Tracking Variance, Not Tracking Error

Because investors who build portfolios that are intentionally more diversified than a broad benchmark index do so with the certain knowledge that their portfolios will perform differently than the benchmark index, that difference is not a result of tracking error (the investor did not want the portfolio to track the benchmark; thus, there was no error). Instead, it is more correctly called “tracking variance.” The problem is that tracking variance leads to two well-documented behavioral errors—recency bias and resulting.  

Recency Bias

Recency bias is the tendency to overweight recent events/trends and ignore long-term evidence. This leads investors to buy after periods of strong performance—when valuations are higher and expected returns are now lower—and sell after periods of poor performance—when prices are lower and expected returns are now higher. Buying high and selling low is not a prescription for successful investing. Yet many individuals invest that way. What disciplined investors do is the opposite—rebalance to maintain their well-thought-out allocation to risk assets.

Sadly, while most investors consider three years a long time to judge performance, five years a very long time, and 10 years an eternity, wise investors know that all risk assets go through much longer periods of underperformance. For example, while the S&P 500 has been the strongest performer among equity classes for much of the last decade, leading many investors to experience recency bias and tracking error regret, there have been three periods of at least 13 years (1929-43, 1966-82, and 2000-12) when it underperformed riskless one-month Treasury bills. And there was even a 40-year period (1969-2008) when they only outperformed long-term Treasury bonds, by just 0.06% per annum. For investors who favor growth stocks, over that same 40-year period those long-term Treasury bonds outperformed both U.S. large-cap growth stocks and U.S. small-cap growth stocks (by 0.46% per annum and 4.07% per annum, respectively). Such examples are exactly why diversification is a prudent strategy.

Recency bias also leads to the problem of engaging in relativism.

Relativism

Unfortunately, too many investors have entered what Vanguard founder John Bogle called the “age of investment relativism.” Investor satisfaction or unhappiness (and by extension, the discipline required to stick with a strategy) seems determined to a great degree by the relative performance of their portfolio to some benchmark index—an index that shouldn’t be relevant to an investor who accepts the wisdom of diversification.

Relativism can best be described as the triumph of emotion over wisdom and experience. The history of financial markets has demonstrated that today’s trends are merely “noise” in the context of the long term. Bogle once quoted an anonymous portfolio manager who warned: “Relativity worked well for Einstein, but it has no place in investing.”

Resulting

One of the more common mistakes both individual and institutional investors make is the tendency to equate the quality of a decision with the quality of its outcome. Poker players call this trait “resulting.” Nassim Nicholas Taleb, author of Fooled by Randomness, provided this insight into the right way to think about outcomes: “One cannot judge a performance in any given field by the results but by the costs of the alternative (i.e., if history played out differently). Such substitute courses of events are called alternative histories. Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”

In my book Investment Mistakes Even Smart Investors Make and How to Avoid Them, this mistake is called “confusing before-the-fact strategy with after-the-fact outcome.” The mistake is often caused by “hindsight bias”: the tendency, after an outcome is known, to perceive it as virtually inevitable. As John Stepek, author of The Sceptical Investor, advised: “To avoid such mistakes, you must accept that you can neither know the future nor control it. Thus, the key to investing well is to make good decisions in the face of uncertainty, based on a strong understanding of your goals and a strong understanding of the tools available to help you achieve those goals. A single good decision can lead to a bad outcome. And a single bad decision may lead to a good outcome. But the making of many good decisions, over time, should compound into a better outcome than making a series of bad decisions. Making good decisions is mostly about putting distance between your gut and your investment choices.”

Good Decisions Can Lead to Bad Outcomes

In his 2001 Harvard commencement address, Robert Rubin, former co-chairman of the board at Goldman Sachs and Secretary of the Treasury during the Clinton administration, addressed the issue of results. He explained: “Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.”

Takeaways

While diversification has been called the “only free lunch in investing,” it doesn’t eliminate the risk of losses. And diversification does require accepting the fact that parts of your portfolio will behave entirely differently than the portfolio itself and may underperform a broad market index (such as the S&P 500) for a very long time. A wise person once said that if some part of your portfolio isn’t performing poorly, you are not properly diversified. The result is that diversification is hard. As Cliff Asness noted in his thought piece “Liquid at Ragnarök?”, “Losing unconventionally is hard.” I would add that because misery loves company, losing unconventionally is harder than failing conventionally. Asness also observed that living through hard times is harder than observing them in backtests. That difficulty helps explain why it’s so hard to be a successful investor. It’s our behavioral biases and the mistakes we make because we don’t know the historical evidence.

It is always a good idea to be a skeptical investor. Thus, there is nothing wrong with questioning a strategy after a long period of underperformance. With that in mind, you should ask if any of the assumptions behind your strategy are no longer valid. Or if the risks just happened to show up. Seek the truth, whether it aligns with your beliefs or not. For investors, the truth lies in the data on persistence, pervasiveness, robustness, implementability, and especially intuitiveness. For example, the three periods (1929-47, 1966-82, and 2000-17) of at least 17 years when the S&P 500 underperformed five-year Treasurys should not have convinced you that U.S. stocks should no longer be expected to outperform the far less risky five-year Treasury note. 

Recognizing that there is no crystal ball allowing us to see which asset classes/factors/sources of risk and return will outperform in the future, the prudent strategy is to diversify across as many of them as we can identify that meet the aforementioned criteria, creating more of a risk-parity portfolio—one whose risk is not dominated by a single source of risk and return. Unfortunately, that is the case with the traditional 60/40 portfolio, where the vast majority of risk is concentrated in market beta, typically 85 percent or more. The problem of risk concentration is often compounded by home country bias (leading to vastly underweighting international equities).

Diversification means accepting the fact that parts of your portfolio may behave entirely differently than the portfolio itself. Knowing your level of tolerance for tracking variance risk and investing accordingly will help keep you disciplined. The less tracking variance you are willing to accept, the more the equity portion of your portfolio should look like the S&P 500 Index. On the other hand, if you choose a market-like portfolio, it will be one that’s not very diversified by asset class and will have no international diversification. At least between these two choices (avoiding or accepting tracking variance), there is no free lunch. It is almost as important to get this balance right as it is to determine the appropriate equity/fixed-income allocation. If you have the discipline to stick with a globally diversified, passive asset class strategy, you are likely to be rewarded for your discipline.

To help you stay disciplined and avoid the consequences of recency, I offer the following suggestion. Whenever you are tempted to abandon your well-thought-out investment plan because of poor recent performance, ask yourself this question: Having originally purchased and owned this asset when valuations were higher and expected returns were lower, does it make sense to now sell the same asset when valuations are currently much lower and expected returns are now much higher? The answer should be obvious. If that’s not sufficient, remember Buffett’s advice to never engage in market timing, but if you cannot resist the temptation, then you should buy when others panic.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed.  Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. All investments involve risk, including loss of principal. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. The opinions expressed here are their own and may not accurately reflect those of Buckingham Wealth Partners. LSR-24-632