The Dangers of Good Performance

May 28, 2015

Last month our Aggressive Powerfund Portfolio, which debuted on March 31st, 2002, moved past the 300% since-inception return mark (recent weakness in bonds and stocks currently put us just below that level). 

With dividends, the S&P 500, as measured by the Vanguard 500 Fund, was up about 130% over this same time period. The performance of our more conservative model has also bested the S&P 500, albeit by just twenty percentage points, but at a significantly reduced risk level than the stock index. (Click here for more on our performance calculation methodology) 

In the warm glow of the rearview mirror, that 300% (or just over 11% annualized) seems pretty grand. But it’s important to look at what actually happened to generate that return and consider how repeatable it is. “Past performance is no indication of future results” is as true for us as anyone else.

We’re always trying to predict what could go wrong next. Is this hot performing growth fund built on a foundation of soon-to-be crumbling biotech stocks? Was this small-cap fund overexposed to commodities on the way up? Is there too much money in this now-popular fund for it to continue performing well going forward? Are value stocks less of a value today? 

Might our overall strategy perform less well in the next five years than the previous five?

Our model portfolio returns have handily beaten so-called fund-of-funds (mutual funds that build a portfolio of other funds, as we do) largely by shifting overall stock allocations and buying the right kinds of bonds and stocks. 

More traditional total portfolios don’t go from 50% stocks to 70% when the market falls or from Japan to Small Cap Value and then Utilities for a few years. They either own a fund category or they don’t. They don’t mix it up over time. 

It’s not that we’re doing short-term trading. These are multiyear positions. But specific categories may essentially vanish from our accounts for years at a time. Our “active” total portfolio strategy may underperform more benchmark-oriented portfolios if these favored areas don’t do well. 

Our favorite benchmark is the Vanguard Star fund (VGSTX). This cheap fund-of-funds puts investors’ money all over the world at low cost. VGSTX is generally more tax-efficient than even our relatively tax-efficient portfolios (We don’t book short-term gains 98% of the time). 

But VGSTX’s managers aren’t going to cut back on large cap U.S. stocks just because somebody at Vanguard thinks they’re overpriced. That’s a key difference between Us and Them.

But determining that large-cap U.S. stock funds are due for a downturn (and being right) isn’t that easy to do. Hunches turn out wrong. Investments that seem attractive are often the most overpriced. That’s why Vanguard STAR, as well as Vanguard Balanced index funds, usually beats broker and advisor-managed accounts. 

The other reason is fees. You start adding 1-2% management fees on top of a bunch of ill-conceived allocation ideas, and you have a recipe for underperformance.

But our allocations are largely built off watching what other investors do and essentially doing something else. We know their calls underperform over time, so doing something else should outperform. 

How We Were Able to Beat Competitors and Benchmarks:


  1. We avoided larger-cap U.S. stocks in the early 2000s, instead focusing on smaller-cap, foreign, and emerging markets.
  2. We shifted more to U.S. larger-cap stocks in the later 2000s.
  3. We generally kept a large bond allocation, particularly longer-term bonds, including foreign bonds in the early 2000s and domestic bonds from the late 2000s through today.
  4. We adjusted stock allocations upward with market declines and vice-versa.
  5. Our fund categories generally did well compared to other options. 
  6. We used funds with short positions that often helped during market turmoil.


What often hurt us was getting out of the good stuff too soon, owning some out-of-favor areas like Japan that never did particularly well, being a bit too conservative in recent years, and keeping too much in cash and short-term bonds.

The stock side of our portfolios no longer beats the S&P 500 by as much as it did in the early 2000s, because we’re now buying S&P 500-type stocks. We’re comfortable with the match. In fact, the S&P 500 has itself beaten most everything else in recent years, especially foreign markets – the sort of stuff we owned in the early 2000s.

Going forward, things are probably going to be a little less exciting, for a few reasons:


  • Bonds aren’t going to add much value. To increase returns, you’ll need to take more downside risk by increasing your stock allocations.
  • We’re at a high plateau. Without at least a mini-crash, it’ll be tough to swoop in and buy cheap for higher future returns. It’d take a hot global economy to lift the boats much higher from these levels.
  • Most investor money is now over-diversified and over-indexed. Indexing and diversifying are great, but if everyone has a global portfolio (much of it, indexed,) it’s harder to see where the mistakes are being made. We’d rather see everyone piling into X so we can clearly avoid it by buying Y. What do you do when everybody owns everything? 


Our theory that investors are more into diversification and less into performance-chasing may be why we’ve seen money flow back into foreign funds. In the past, after years of underperforming U.S. stocks, we’d expect to see money leaving foreign stocks in favor of U.S. stocks, but it’s not. It’s continuing to flow into foreign stocks. Could this money going abroad anew be the result of simple rebalancing?

If your goal is 20% foreign stocks and 40% U.S. stocks, and U.S. stocks do well and foreign doesn’t, you move money into foreign to rebalance. Of course, that’s better than chasing U.S. outperformance, but it doesn’t give us a clear signal where to go or when to buy foreign and sell U.S. 

This is a change in strategy for investors. In the late 1990s, people sure didn’t sell their hot tech stocks and rebalance into small-cap value stocks, or out of stocks and into bonds. We need dumb money placing bad bets, not everybody throwing in the towel and buying a basket of global index funds.

Returns go up when there’s less money in your area of investment looking for returns. If everybody is everywhere, it’s all going to be so-so. What you don’t want is overconfidence based on your own past performance.

That’s one reason performance turns sour. You believe in your own infallibility.