A broad index fund is one way to get international exposure in your portfolio, but index funds aren’t perfect. One alternative is to pick single country funds but how do you choose which countries to own?
The problem with picking any fund is our reliance on recent performance. This is a common mistake investors make – chasing returns. Without a plan, the best performing funds are the first ones picked every time.
The investing world we live in tempts us with one, three, and five-year returns on every stock and bond fund around. We love to own what’s going up, we hate to miss out, so we chase returns of the best performing funds of the recent past. Sometimes it works, but not always.
The results below show what happens when you pick the best performing country funds instead of owning a broader international index fund.
Buy and Hold vs Picking the Best Countries
To show the impact of chasing returns, I’ll use the MSCI EAFE to represent a buy and hold strategy with an international index fund. The Top 5 Countries is an attempt to cash in on the best performing countries from the recent past. Every January 1st you reload your portfolio with the five best performing countries over the past five years.
|Buy and Hold vs Picking Top 5 Performing Countries for 1 Year|
|MSCI EAFE||Top 5 Countries*|
* Developed Countries ex U.S. and Canada over 39 year period from 1975 – 2013
Over the long run, this strategy misses expectations. When you toss your plan to chase the best returns, your results fall short of the average index. Average isn’t great, but its better than no plan.
But looked at on a year by year basis some investors might confuse the results. The best performing countries do beat the index sometimes. Those teaser years cause you to ignore your process, your plan, your time horizon, and chase those returns because if it happened one year it can happen again, right? Sometimes it works.
Actually, about half the time it works – 20 of the 39 years. A coin flip. Often enough that an investor might continue chasing the same five countries. If it worked once, why shouldn’t it work again?
The Chase Continues
When it works half the time, its easy to see why an investor would stick with it for a few more years. The table below shows what happens when you press your luck.
|Average Annualized Returns When Held for the Following Years|
|2 Years||3 Years||4 Years||5 Years|
|Top 5 Countries||10.51%||9.04%||9.09%||9.42%|
After two years, you can see this strategy is a losers game. By chasing returns, you’re naturally buying markets near the end of a big positive run. The timing isn’t perfect but it reflects the mistake many investors make of buying high. After a stretch of above average returns, markets (and assets in general) revert back toward the average. For that to happen, markets need below average returns.
Eventually, that Top 5 Country portfolio bottoms before it slowly reverts back toward its average again. Though, I doubt an impatient investor who chases returns will stick around to see that happen. They’ll be too busy chasing a new set of best performers to compound their mistake.
Not having a plan or a process in place is one of the biggest mistakes an investor can make. It’s like driving in a strange land without directions. Whats more likely to happen – luck somehow gets you to your destination or you end up lost without a map?
Stock markets don’t go in one direction. This is exactly what makes investing great and frustrating at the same time. Investing isn’t a field where the smartest people are the best investors. Knowledge helps, but discipline has a bigger impact on your results in the long run.