The Trouble With Being Different

I used AI as an editorial assistant to help organize and refine my thoughts; the underlying ideas and personal experiences remain my own.

During the stock market boom of the late 1990s, an acquaintance of mine jokingly started an experiment. He tracked the daily performance of the S&P 500 alongside his own mood. I don’t know whether he ever calculated the correlation, but I suspect most of us would find one.

I was reminded of his experiment while reading Mark Crothers’ recent HumbleDollar article, Doubling the Bear Market Low. Investors heavily invested in stocks could have seen their holdings double since the October 2022 market bottom. Those of us with more diversified portfolios may be perfectly satisfied with our results until we see how much better someone else has done.

Suppose your portfolio returned 12% in 2024. Would you be happy? Probably, until someone pointed out that the S&P 500 returned about 25%, including dividends. Nothing about your finances has changed, yet a respectable return suddenly feels disappointing. Whether we admit it or not, many of us measure our investment success against the S&P 500.

Here’s the contradiction. We diversify because we want investments that behave differently from one another. Yet when they actually do, especially during a prolonged bull market, we become uncomfortable. We want the benefits of diversification without the inconvenience of falling behind.

Falling behind, however, is part of the bargain. Bonds, international stocks, and alternative investments such as managed futures or cat bonds can provide exposure to different sources of risk and return. Consider two investments, each with annual volatility of 15%, whose returns are uncorrelated. Combining them in equal proportions reduces the portfolio’s volatility to approximately 10.6%, even though one investment might trail the other for years. The mathematics are straightforward. Living with the results can be harder.

Larry Swedroe has written about tracking variance risk, the possibility that our investments will perform very differently from a familiar benchmark. That difference isn’t necessarily a problem if we never intended to track the S&P 500 in the first place. But the discomfort is real, particularly when a rising market reminds us of the returns we’re missing. It can become costly if we abandon a sound investment strategy after several disappointing years and move our money into whatever has recently performed best.

For retirees, choosing the right benchmark is particularly important. A portfolio designed to fund withdrawals, preserve purchasing power, and limit large losses shouldn’t necessarily be judged against an all-stock index. If our financial plan is working at a level of risk we can live with, should we be disappointed because the S&P 500 has done better? That doesn’t mean ignoring investments that have stopped doing their job. It means judging our portfolio against the objectives we established for it.

An old investing adage holds that if everything in your portfolio is making you comfortable, you’re probably not sufficiently diversified. It’s not an absolute rule, but it captures something important about investing. Perhaps that’s the lesson I should have taken from my friend’s experiment. Rather than worrying about the correlation between the S&P 500 and our mood, we should ask whether our portfolio is doing what we designed it to do. The next time an investment disappoints us, it might be worth considering whether it has stopped serving its purpose or whether we’re simply uncomfortable watching something else do better.