The kind of investment risk

I recently attended the Garrett Planning Network conference near Denver, CO. What a nice break from the Texas summer heat! One of the sessions highlighted an issue many of us are dealing with right now: frame of reference risk.

We usually think of investing risks as external events that could impact performance. But frame of reference risk refers to the possible negative impact on investing performance of something we might do to ourselves!

Think about what your frame of reference is. For most of is, it’s the US stock market. It’s the Dow Jones or the S&P 500. But then think about what’s in your portfolio. Hopefully, it’s a lot more diversified than just the US stock market.

When the US stock market is doing poorly (like during 2007 – 2008 or the early 2000s), you’re really happy to be diversified. You’re hearing horrible reports on the news about how the Dow is down 10%, 20%, or more. You’re looking at your portfolio, and it’s down, but not that much. So you feel wise, and you’re happy to commiserate with your friends about the market’s performance and your diversification strategy.

But now think about what we’ve been living through over the last 6 years. Or in the second half of the 1990s. The US stock market has been going gang-busters. US stocks were the top performing developed market country for the last 2 years in a row. And how is your diversified portfolio doing now? Less well. If it includes some bonds, some international stocks, and possibly some other diversifiers, those holdings have been a drag on your performance. So when you hear another stellar report about the the S&P 500 or the Dow, you feel a little sheepish. It’s one thing to have your diversified portfolio under-perform for 1 year or 2 years, but when it becomes multiple years in row, it becomes a little hard to take.

And this is what frame of reference risk is.

It’s the risk that we might abandon our diversified portfolio strategy at exactly the wrong time because we just can’t stand to not do as well as the benchmark against which we’re judging ourselves.
 It’s human nature to compare. And human nature to want to act on that comparison.

But this is a time when we need to let science and history be our guide. Remember back to those that abandoned their diversified strategy in the late 1990s and went all-in to US stock just before the dot-com bubble burst. Their portfolios were massively damaged.