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Investing: Why broader is better

(MoneyWatch) What stock sector will outperform next year? Will commodities outperform stocks? Will emerging market bonds provide extra returns? It turns out that investing based on researching these questions is quite destructive.

Last month at the Bogleheads 2013 conference, Vanguard Senior Investment Strategist Joel Dickson, gave a presentation on the crazy things investors do. That investors move into stocks after surges and sell after plunges causes investor returns to lag fund returns. Using Morningstar data, Dickson illustrated this lag in the categories below.

While investors chased performance in every category, the shortfall was greater the narrower the category. For example, stock sector funds lagged by 1.53 percent annually versus only 0.58 percent annually for broader stock funds. While not on this chart, Vanguard determined that investor intermediate-term bond funds lagged by 1.37 percent annually, while narrower bond categories like high-yield bond lagged by 2.45 percent, and emerging market bonds lagged by 3.36 percent annually.

The implications to investors are huge. The combination of sector funds makes up the entire market so we know that, in total, all of the sectors must give the market return but will have more volatility. Yet investors are more likely to time the sectors poorly by chasing performance. The same is true in foreign stock and bond categories.

So, if you or your advisor are picking narrow slices of the market, your likely outcome is not just greater volatility, it's also a lower expected return.

Don't fiddle with your asset allocation. Stay away from any narrow investment strategy, especially if it has recently been hot. Broader low cost funds like total U.S. stock, total international stock, and total bonds are much better. Rebalancing regularly has historically led to higher investor returns over the fund returns.

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