Average Is Boring (And Competitive)

Jeff Troutner of Equius Partners laments that too many investment advisors too often succumb to the temptations of extreme and overly active portfolio strategies despite the rise of indexing. Indeed, he suggests that indexing has been hijacked and perverted. “Thousands of advisors, who long ago convinced themselves and their ever-changing clientele of their intellectual superiority over ‘the market’—only to be consistently humbled by it—have shifted their strategies from individual stock picking to ETF picking with a market timing overlay.”

Troutner’s worry is surely well founded. Academic research as well as anecdotal evidence suggest that a large percentage (a majority?) of individuals, financial planners and institutional investors who manage portfolios on the assumption that they’re smarter than average end up paying a price, particularly after deducting taxes and trading costs.
How to resolve this challenge? There are a thousand ways to approach the problem, but I believe that everyone should begin by considering the default portfolio that’s comprised of all the major asset classes weighted by market value. This is recurring topic on these pages, but a worthy one, in part because it’s so widely ignored. Most investors overlook this benchmark at their peril. Just as you should have some perspective on the baseball diamond you’re set to use for a game, it makes sense to understand the financial and commodity markets you’re intent on competing with as you build and manage an investment portfolio. For unknown reasons (or maybe they’re not so unknown), most investors overlook this critical point.
That includes overlooking the fact that a market-value index of everything (or at least all the major asset classes that are available as broadly defined ETFs) generates a competitive return over time. That’s no surprise. Indeed, more than half a century of financial research predicts no less.
For example, in an earlier post this month I updated my Global Market Index’s returns and compared it with the major asset classes. Over the past three years, for instance, GMI looks strong, or weak, depending on the individual asset class you pick for comparison. That’s always going to be the case, and it holds up over time.
More importantly, GMI is competitive with the various active asset allocation efforts. In fact, as I discussed recently, GMI’s trailing 10-year record has been well above average vs. more than 1,000 multi-asset class mutual funds over the past decade.
The point isn’t that everyone should pile into GMI or something comparable, although you could do a lot worse. Rather, the issue is considering the default portfolio as a first step in designing an asset allocation that’s right for you. In short, the most important investment decision is deciding how to customize Mr. Market’s asset allocation. The second most important decision is deciding how to manage the mix through time. The second question is a far more complicated topic, of course, but the first step is pretty easy and, IMHO, intuitive.
One might wonder why the merits of a broadly defined passive asset allocation are so often overlooked if not dismissed. Troutner’s complaint that indexing is “boring” is probably a big part of the answer. Now it’s true that you can go overboard with boring as well. Even the greatest asset allocation in the world still needs adjusting through time. But that’s another subject entirely, although it doesn’t have much relevance if you flub the initial portfolio design.
Granted, there are no silver bullets here. The optimal portfolio mix is unknown for a simple reason: the future’s uncertain. What we do know is that GMI’s long-run performance is likely to be middling to slightly better than middling vs. all world’s efforts to enhance GMI’s average performance.
Alpha must sum to zero in the end. That inspires looking at a robust benchmark that holds everything in passive weights as a starting point. You can rationalize avoiding one or more of the asset classes; ditto for reweighting the allocations. But you shouldn’t do so out of ignorance or boredom. For most investors, unfortunately, that’s the typical response, which goes a long way in explaining why the average investor generally earns well below the average return of the market portfolio a la GMI.