Optical Illusions in Investing

Do you remember “The Dress”? From way back in 2015? Sure, hundreds of internet sensations memorable for one reason or another have gone viral over the years, but this one made a splash by any standard. Is the dress white and gold? Or is it really black and blue? Debate raged and The Dress forever earned a place in pop culture. It seems, though, that everyone at the time simply forgot about optical illusions and the tricks our brains can play on us.

While things like The Dress can be fun and, at their worst, elicit some argumentative conversations among friends and family, similar psychological phenomena are common in the investing world, too. They just often come with more severe implications. Our various cognitive tendencies make us all prone to errors in assessing information objectively, behavioral mistakes, and heuristic thinking. Maybe at some point over the last few years they’ve led you to ask, “Why am I underperforming the S&P 500?” The short answer is something called tracking variance, which is how much your performance differs from a common index benchmark. If this question is on your mind, you’re likely significantly more diversified than the S&P 500. The longer answer, however, is why.

As with many things in life, the devil is in the details. The details in this case are that the S&P 500 is dominated by only six companies, collectively referred to as the FANMAG stocks: Facebook, Apple, Netflix, Microsoft, Amazon and Google. These six companies currently account for a staggering 25% of the entire S&P 500,1 and history shows that this is not uncommon. This illustrates that, while the returns to this popular index have been impressive in recent years, it does not represent a diversified investment strategy. In fact, a strategy that invests solely in the S&P 500 would be highly susceptible to what’s called portfolio concentration risk: the risk of amplified losses that may occur from having a large portion of holdings in a particular investment, asset class or market segment relative to the overall portfolio.

When exploring the potential downside of concentration risk, look no further than the period from 2000 through 2009, commonly referred to as the “lost decade.” During this period, the S&P 500 recorded its worst ever 10-year performance with a total cumulative return of -9.1%. At the same time, many asset classes outside the U.S. experienced much more favorable returns. While this may be a more drastic example, the U.S. equity market has actually underperformed the world equity market in six different decades dating back to 1900.2 As you might have guessed, the solution to mitigate this unnecessary market risk is rooted in diversification, which helps to maximize expected return based on a given level of market risk.

Maintaining a globally diversified portfolio means accepting some degree of tracking variance, and that can be difficult when some well-known domestic index is up more than you are (even though many financial economists believe that diversification is the only free lunch in investing). But your portfolio and the S&P 500, for instance, simply are not an apples-to-apples comparison. For starters, remember that your portfolio is built to mitigate the concentration risk characteristic of indexes like the S&P 500. Next, recall that tracking variance can be like an optical illusion, a psychological misdirection that beguiles you into assuming a positive correlation between your investment performance relative to the S&P 500 and the success of your financial plan – when in fact no such relationship strictly exists.

This illusion is exacerbated because popular indexes are constantly on display and exhaustively discussed among talking heads in the financial media. This makes it difficult to block out the noise and focus on what’s truly important: the design and implementation of your financial life plan.

Thoughtful financial life plan design means tailoring your investment portfolio to your financial goals based on the highest statistical probability of success. So a more appropriate measure of success than beating the S&P 500 is the amount of progress you’re making toward the goals you’ve identified. Many investors do in fact own the S&P 500 in some capacity, because it provides exposure to some of the most successful companies in the United States. But it’s best owned as part of a globally diversified portfolio that’s personalized to your needs.

1. As of August 31, 2020. Data is from Morningstar.

2. Annual country index return data from the Dimson-Marsh-Staunton (DMS) Global Returns Data provided by Morningstar.

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.

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This article is for general information only and is not intended to serve as specific financial, accounting or tax advice. IRN-20-1165

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