"Tracking error" regret is a real risk

(MoneyWatch) Investing in stocks involves accepting economic and political risks in return for higher expected returns than you can earn investing in Treasury bills or CDs. To help address these risks, investors can diversify their investments. However, the pain of trailing common benchmarks is something that diversified investors must take into account to be successful.

The benefits of diversification are well known. In fact, diversification is often referred to as the only truly free lunch, because done properly it allows you to reduce the risk of your portfolio without reducing expected returns. Even William Shakespeare, in "The Merchant of Venice," showed that he understood the importance of diversification. As one character in the play says, "My ventures are not in one bottom [ship] trusted, nor to one place, nor is my whole estate upon the fortune of this present year. Therefore, my merchandise makes me not sad."

Unfortunately, my experiences as both an investor and advisor have taught me that diversification isn't truly a free lunch for most investors -- with it comes the very real risk known as "tracking error regret."

Tracking error is defined as the difference between a fund or portfolio and a benchmark. Most often the benchmark is a commonly referred to index such as the S&P 500 Index. If your portfolio consists solely of an investment in an S&P 500 fund, you're not exposed to any tracking error risk. However, your portfolio isn't well diversified, being exposed only to large-cap U.S. stocks. Once you diversify beyond that index, you are taking the risk of tracking error.

Why investors should diversify sources of returns
Should you dump your international stocks?
How innovation affects stock prices and returns

Most investors never question a divergence in their returns from a benchmark when it's positive. But when tracking error is negative it can lead to investors questioning, and even abandoning, their investment plans. And that's the danger.

We'll take a look at the problem tracking error creates, beginning with a look at what happens when you add international investments to your domestic portfolio.

In each of the past two years, a stock portfolio split 60/40 between the S&P 500 Index and the MSCI EAFE would have underperformed the return of just the S&P 500. With two straight years of lagging returns, it can become easy to forget that in seven of the previous eight years, such an allocation beat the S&P 500. Unless investors can tolerate negative tracking error and rebalance their portfolio when appropriate, an international allocation won't be of much value. In fact, it can be a real negative because plans will be abandoned after periods of poor performance and expected returns are now higher.

The risk of tracking error regret isn't limited to international investments. It also can rear its ugly head with great frequency in U.S. markets. Investors who wish to diversify their domestic holdings beyond the S&P 500 also take on significant tracking error risk.

The message I hope you take away is that there's no one right portfolio, just one that's right for you. I believe that the most efficient portfolio is one that diversifies across not only geography, but also asset classes (or risk factors). However, if you can't live with tracking error regret, your portfolio should look like "the market," or whatever benchmark you follow. You'll sacrifice some of the benefits of diversification, but you're more likely to be able to stay disciplined, adhering to your plan. And that's the most important part of playing the winner's game.