Most financial advisors and investors want to build a portfolio based on what has worked historically. There is nothing wrong with that. In fact, it would be foolish not to pay attention to how potential (or actual) investments performed in the past. How we look at the past, though, can dramatically alter our conclusions. Consider the following cases:
The year is 1999 and Jane Investor wants to build a high performance equity portfolio. She analyzes some different funds and looking at the last 5-10 years figures out:
International stocks have been a major drag on performance; it would be better to just hold US stocks.
Large cap growth stocks in the US have outperformed small caps and value stocks.
Over the next decade US large cap growth stocks proceeded to dramatically underperform almost every other type of stock fund.
The year is 2010 and Joe Investor is trying to do better than the last 10 years. He was 90% US stocks and 10% international stocks. Large cap US stocks have had a horrible decade, while international stocks have had a much more productive decade. Joe decides:
If I overweight my portfolio to international stocks and smaller company stocks I should significantly enhance my return.
Over the next decade international stocks and small company stocks underperform large cap US stocks.
The lesson is this: brief backtested periods will create a poor canvas on which to design your portfolio. Try looking back at least 25 years and consider ending your test before the last five years. Develop a static portfolio allocation approach and stay with it. If you broadly allocate your portfolio, you won’t have the top performing portfolio, but you won’t have to suffer through a decade of futility, either.