Wednesday, June 24, 2015

And The Winner Is....

The best performing developed market of the past 20 years will come as a surprise to most.  The fact that an investment in this country nearly doubled the return of the US during this time will be even more surprising.  But the most interesting aspect about this country's performance is how it became the best performing developed country over the last two decades.

Before I reveal who it was I am going to give you a chance to figure it out for yourself.  Below is the well know "Quilt Chart."  This chart ranks the performance of each country from 1995 to 2014.  Each country is represented by a different color.  The best performer for a given year is at the top, the worst at the bottom.

Do any patterns emerge that may give you a hint to who did best?  If the chart appears random it is because that is the point.  It is very difficult to determine any persistent pattern over time from this chart, yet there is a very clear winner.  Maybe the same chart in a different format will be more telling. Below is the same chart organized by country.  If the country was the top performer for any given year its return is highlighted in the country's color.

An intuitive guess would be whichever country had the most years ranked as #1.  Switzerland had three #1 years as well as New Zealand.  Switzerland did crack the top 5, but New Zealand was actually in the bottom 5!  The US had two #1 years but we already know it returned a little more than half of the best country.  Clearly being top of the list on any given year is no indicator of long term performance.  And that revelation is exactly what makes the top performing developed country of the last 20 years so interesting.  Take a look at Denmark in the chart above and count how many years it was the best performing country.  The answer is zero.  And do you know what the best performing country was over the past 20 years?  You guessed it.  Denmark.  One million dollars invested in Denmark in 1995 would have grown to over 10 million by the end of 2014.  Compare that to the US which would have turned one million dollars into 5.9 million.

There is a clear takeaway from this information.  Year to year performance has no direct correlation on long term results.  In fact, like the case with New Zealand, high annual performances may indicate too much volatility which correlates to lower long term performance.  This is where the danger lies for many individual and professional investors alike.  Chasing recent returns can be very hazardous to your investing health.  If you constantly change your portfolio to try to mimic what has recently done well or you try to bet on what will do the best next year you stand a very real chance of increasing volatility and lowering long term returns.

The above charts give us good information on what not to focus on.  But what, if any, information do they give on what can be beneficial to long term success?  One last variation of the chart gives some valuable insight into why Denmark did so well the past 20 years.

Above is the original quilt chart but I have isolated the US and Denmark.  The major thing that stands out is the volatility in year to year performance.  While Denmark never had a number #1 year you can see that it consistently scored in the upper 50th percentile with NO last place years.  The US on the other hand demonstrated much more volatility having two #1 years but also a worst place finish  in 2004 and two second to worst years in 2003 and 2006.

The moral of the story is consistency is key and volatility is bad.  You may now be saying, "But how can we apply this to our investing?  We only know after the fact Denmark did so well and we certainly are not going to bet our entire retirement on one country." You would be correct in saying this, but there is a way to capture the desirable characteristics of Denmark without betting on one country.

The answer is: Diversification.  There is a reason why diversification is considered the only free lunch in investing.  By incorporating many different assets into a portfolio you are systematically ensuring you will never be the top performing OR the bottom performing portfolio.  By maintaining the appropriate mix of each asset class and rebalancing as the market dictates you will reduce volatility and increase long term performance.  The only performance that really matters.

In conclusion, high one year performance not only has no correlation with long term investing success it actually can correlate to lower returns if there is accompanying higher volatility.  If you want to win long term maintain a diversified portfolio that is matched to your risk level and investment goals.  And lastly, find someone who is skilled enough to do this for you.  This example only scratches the surface of the complexity of investing.  An advisor who can build you an efficient portfolio and keep you focused on long term goals is an invaluable asset to have.

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