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Can You Handle the Truth About Tracking Error?

To a point, I'm glad that the current market climate (at least as we write) has caused some investors' globally diversified portfolios to underperform the familiar S&P 500 Index this year. Why might this make me happy? It could be the best, "tough love" learning experience ever if you can handle the truth, which is as follows: The difference between planning for the atypical market risk inherent to diversified investing and experiencing the actual pain when it occurs reminds me of a quote from heavyweight champion Mike Tyson (who certainly knows his way around pain): "Everybody has a plan until they get hit."

Stick to Your Plan
My goal is to help those who have wisely adopted a diversified investment approach to remember their all-important plan. The point of diversification is to intentionally spread your investments across a variety of holdings with varied expected risks and returns. This helps you pursue your own financial goals instead of an arbitrary benchmark.

For those of you who have tilted your diversified portfolio toward holdings with higher risk/return levels, it should come as no surprise when you experience occasional, potentially significant (and sometimes even relatively lengthy) underperformance compared to the status quo. The bumpier ride is the price paid for the expected long-term returns you're pursuing. It's part of the plan.

Tracking-Error Regret: Cause and Effect
Even so, you may still be questioning your plan now that you're seeing it in action. If that's the case, it might help to know that you are not alone in feeling some self-doubt. The financial industry even has a term for it: tracking-error regret.

Tracking-error regret occurs when your carefully designed investment portfolio underperforms popular market benchmarks. If your own portfolio's growth seems anemic in comparison, you may regret the decisions you've made and wonder if you'd best make some changes to go after that greener-looking grass. Before you switch gears, ask yourself: Are you using the right gauge for the measurement?

To us, financial success isn't defined by how closely your returns happen to match a common benchmark. Instead, it's about you and yours. On those terms, financial success happens when ...

1. You and your family have enough wealth to achieve or sustain your desired lifestyle according to your personal goals.
2. You are able to focus the majority of your time and energy on doing the things you enjoy with the people you love, instead of worrying about financial headlines.

We achieve this measure of success in several ways. The general rule of thumb is to concentrate on actions you can expect to control and avoid being entangled by those you cannot.

Investment Management Entangling Activities
Minimizing investment costs Hyperactive (expensive) trading
Forming a personalized investment plan Second-guessing your carefully laid plans
Building and maintaining a customized portfolio that reflects that plan Trading based on reactions to outside events
Measuring success according to whether you are on track to achieve your personal goals Assuming faire if your portfolio doesn't always track a common benchmark

Investing Like a Champ
The final point in the table above gets to the heart of why it's critical to avoid tracking error regret. Think of your custom-built portfolio in the same way. Its highest purpose is not to slavishly track a common index. Your portfolio should instead be designed for – and measured against – a far greater purpose: You and your desired destinations. Keep your eyes on that prize, and you stand the best chance of being able to roll with the punches.