Beating the market is not something every investor can do. In fact, most investors end up underperforming the market. There are several ways to deal with portfolio underperformance, but it is important to keep a few things in mind. The first, and perhaps the most important is that short-term underperformance is not so important.
Price fluctuations in stocks or funds over a short period of time are usually noise and should be taken lightly. Even during a few years, your portfolio might underperform a certain index. Take for example Warren Buffett’s underperformance during the late ’90s as an example. Most of the financial publications at the time were questioning the Omaha Oracle ability to make investment decisions. In retrospect it was foolish, and it was the ultimate representation of the market's folly and irrational exuberance.
If underperformance persists for a sustained period of time, then you should start to consider the following things:
Analyze your holdings
Start by analyzing your holdings one by one. One of the best pieces of advice we give investors is to carry an investment diary. Write down not just every trade you put in, but the investment thesis behind it. This is a very simple and useful tool for your future self. It allows you to go back, and understand the reasons behind every investment decision. You can easily analyze if your views on the company or the sector have changed. Putting things in retrospect allows you to review each one of your portfolio holdings in a thorough way.
Consider what has changed in the company since you first bought the stock. Is the long-term outlook unchanged? Are there any new developments that might justify its price decline? How does that fit into your initial investment thesis? These are some of the questions you should ask yourself to analyze each holding individually.
Analyzing each holding allows you to identify mistakes. Try to be as skeptical as you can towards your past decisions. Was your investment thesis flawed? What has changed since you initially made the investment? Did you ignore a specific aspect that you should have considered to be more important?
These are some of the questions you can ask yourself. The ability to ignore our own mistakes is ingrained in human behavior, so it is often a difficult topic to discuss with ourselves. It is important to understand that we all make mistakes, the biggest mistake however is not learning from past mistakes.
Identify exactly what you did wrong, and fix the mistake. While fixing the mistake does not necessarily mean selling a certain stock. Your mistake could have been for example to overpay for a certain stock. Once again I advise you to write down your mistakes in your investment diary so that in the future you can avoid similar situations. Perhaps one of the most important lessons in investing is to always learn from your past mistakes. This allows you to avoid most of those mistakes in the future.
Analyze your portfolio
When it comes to investing there is more than just choosing the right stocks. Building a portfolio requires more than just picking stocks. You need to have a clear vision of what the weight of every holding should be. Sometimes underperformance can be reversed just by balancing out the investment portfolio. Consider the weight of every individual holding, not only individually but in terms of the overall portfolio.
Consider the amount of diversification you have, and what risks could seriously affect your portfolio performance. Another important factor is to try and define your goals and build your portfolio accordingly. How diversified do you want your portfolio to be? Do you prefer to concentrate on just a few positions?
You should be able to answer these questions and build or adjust your portfolio accordingly. Underperformance can be directly tied to diversification and the overall weight of your holdings within the portfolio.
Consider your sector and geographical exposure as that might be influencing your underperformance.
Consider the market conditions
Sometimes due to several regions a certain sector, or a group of stocks can underperform for a number of reasons. Consider if that was the case, and what will happen in that sector or group of stocks in which you have the largest exposure.
How would you choose your largest position?
This is perhaps one of the most interesting questions to ask yourself when building a portfolio. There are usually two spectrums of answers although some tend to find themselves somewhere in the middle. Some investors usually choose their largest position based on the possibility of large future returns. Although this in theory seems like the best decision to capture alpha, it might not be the best decision in terms of portfolio risk management.
Some investors tend to be more cautious, and for that reason, they choose their largest position based on their perceived possible risks. This seems by far to be the most sensible option. Some investors will make a choice based on the two factors. Sometimes the returns might outweigh the risk in their judgment or the other way around.
We believe choosing your largest position should be directly influenced by both factors. You should also take into consideration your investment horizon, and try to incorporate it into your decision. On one hand, you don’t want to choose your largest holding solely based on the possible returns.
You will find yourself with a large holding that might be too risky to hold for the long term. On the other hand, you want to choose something that is safe and will most likely deliver a good long-term return.
Balancing both the possible returns, as well as the risk can be a challenging endeavor. Although there is no right answer for this question as it depends on the individual investor - we believe the sensible answer lies somewhere in the middle. Combining the possible returns with low risk.
Final views on portfolio underperformance
As you see there are several approaches to dealing with portfolio underperformance. It might happen for a number of reasons, and it is important for you to determine why it is happening. If you do so you will be able to reverse the outcome.
You will also be able to employ what you have learned and incorporate it into future good investment decisions. In your investment journey, you have to make sure that you constantly oversee everything you do. Do not be complacent with your own mistakes, as the market usually punishes that type of behavior.
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