Many years ago, I played high school baseball. I was a light-hitting infielder with a weak arm, but I was decent at scooping up ground balls. Our coach, a former college player, had a magical touch with a fungo bat; he could make a baseball dance—hard grounders, towering pop flies, with spins that would exaggerate the ball’s movement. On one windy, cloudless spring day, he decided to test us with his aerial arsenal. The baseballs seemed to defy physics, often falling harmlessly to the ground. Each miss was met with a loud "Eeeeeeeeeee" (short for error), and we’d quickly find ourselves benched after making one. We all quickly came to appreciate that our coaches would not tolerate many errors.

A few years later, when I first started in the investing business, my job was to take stock, bond, and options trades from clients over the telephone. This was the early 1990s, before most investors could buy or sell stocks from their personal computers or mobile devices. I was literally a middleman between the customer and the back office trading desks that actually transmitted the orders to the appropriate exchange or market. One particular month, during a time that we were extremely busy, I was working double shifts for overtime pay and made a few mistakes. Those trade errors wound up costing the company money, and subsequently I received coaching from my manager about how damaging errors are to the customer’s trust and the company’s bottom line. That only reinforced my belief that errors are just as bad, if not worse, in investing than they are in baseball.

But what if I told you that in investing, some errors are not just acceptable but desirable? Here, I'm talking about "tracking error," a term that, if properly understood, can make you a better investor.

Recognizing Tracking Error
To begin with, what exactly is a tracking error? It is a measure of the degree to which the returns of a portfolio deviate from those of its benchmark. Low tracking error indicates that a portfolio's performance closely matches that of its benchmark. This might suggest a lack of significant diversification if the portfolio mimics the benchmark too closely.

High tracking error suggests that the portfolio deviates significantly from the benchmark. This could indicate better diversification if the deviations are due to deliberate choices in asset allocation, sector exposure, or other investment strategies aimed at reducing risk or capturing unique opportunities not reflected in the benchmark.

Exhibit 1. Asset Performance 1/1/2015 - 12/31/2024

Since you can’t actually invest in an index, I used one of the most popular large company index funds, Vanguard 500 Index Admiral Fund (VFAIX), compared to the original small company fund from Dimensional Fund Advisors, the DFA US Micro Cap Fund (DFSCX), showing a hypothetical $100,000 investment for the ten years ended December 31, 2024. The “error” would have cost an investor over $106,460 over the last decade had they chosen the small company fund versus the large company fund. I also included the DFA Large Cap International Portfolio (DFALX) Vanguard’s Federal Money Market (VMFXX) to show that tracking error has been negative for other asset types over the past decade, if the S&P 500 was your benchmark.

But now let’s look at another time period, this one ending 12/31/2009.

Exhibit 2. Asset Performance 1/1/2000 - 12/31/2009

As you can see in Exhibit 2, it was a much different story for the small companies at the turn of this century.

Investors get nervous when they consider that their portfolio might be doing differently than "the market." But that difference can be an indication of diversification, even though they may be positive or negative over periods of time. Perhaps the biggest shame is that our worst instincts can lead us to dump investments that aren’t doing well at precisely the time we may actually start being rewarded for taking the risk in the first place. What would you have been inclined to do in 2010 if you had $100,000 to invest? Would you have purchased the DFA small-cap fund or the Vanguard large-cap fund if offered the choice? How about today?

Diversification: The Free Lunch
Most investors understand that diversification has advantages over placing all of your eggs in one basket, or in this case, one asset class. You will encounter tracking error if you diversify across various asset classes, company sizes, countries, etc. However, this is a feature rather than a bug.

Investors typically rejoice when their portfolio beats a benchmark (positive tracking error) but become alarmed when it falls short (negative tracking error). However, this response is often misplaced. The objective is to attain a return profile that aligns with your investing objectives and risk tolerance, which may differ significantly from the S&P 500 or any other benchmark you're employing. This is where tracking error's beauty lies: it's an indication that your portfolio may be diversifying your risk as you expected.

The Battle of the Mind
The psychology of tracking error presents one of the largest challenges to investors. Watching your diverse portfolio fall short of a well-known benchmark might cause you to make bad choices, such as giving up on a carefully considered plan at the wrong moment. The worst part is that if you're diversified, you shouldn't try to replicate the market. You are destined to navigate through a variety of waters, some calmer than others, but always with the purpose of achieving your financial objectives with the least amount of danger.

Long-Term Viewpoint
Diversified portfolios may underperform across a number of years; however, these portfolios can still offer superior risk-adjusted returns over the long term. Knowing that your diversification plan is like having insurance against market downturns in particular industries or areas, the important thing is to maintain the course rather than react to short-term deviations from the benchmark.

While most investors anticipate long-term outperformance of stocks over cash, US stocks have underperformed cash in three distinct 15-year periods since 1926. That is nearly half the time you would have been trailing risk-free cash over the last century had you been invested in the S&P 500 (or equivalent). While it is easy to see these trends in the mirror, it isn’t obvious beforehand.

We can apply similar expectations to other assets like real estate, gold, cryptocurrencies, art, catastrophe bonds, etc. We just don’t know WHEN the outperformance will occur. If some are rising while others are falling, that is the definition of non-correlated returns, which is an attribute we seek in diversified portfolios.

Biases in Behavior and Error in Tracking
Tracking errors may appear to be an issue when it is actually a component of the strategy due to recency bias, which occurs when we place an excessive amount of weight on recent events. Investors frequently purchase high following periods of strong performance and sell low following periods of poor performance—exactly the opposite of what we should do. By avoiding placing all of your trust (and money) in the performance of a single market, a diversified portfolio with an intrinsic tracking error is intended to offset such behavioral blunders and the subsequent drawdowns that can result.

How should you interpret a tracking error, then? In some respects, it can take a while to see that a tracking error is demonstrating the benefits of diversification, but that isn’t to say that benchmarks don’t matter. Just make sure you are using benchmarks that are relevant to your portfolio. If you are invested in a 60/40 stock/bond portfolio, your benchmark may include the S&P 500 for the stock portion if you are invested in large company US stocks, but you should find a comparable bond benchmark for the fixed income component and apply those proportionally. If you own foreign stocks, you should add in a benchmark that proportionally represents those assets. Continue that process until you have a relevant yardstick for measuring your portfolio.

Ultimately, building a portfolio that fits your risk tolerance and investing horizon is more important than beating the benchmark every quarter or year.

You should welcome tracking error rather than be afraid of it if you want to invest like an expert. Knowing that your investments aren't all riding the same wave is what should give you the peace of mind. It's what allows you to profit in various market conditions and, in the end, what could result in a more secure, prosperous investing path.

For the diversified investor, tracking error is evidence that you're approaching your financial future with consideration and strategy rather than merely following the herd. Although it may be unsettling at times, deviating from the norm is frequently the way to long-term success. The next time your portfolio differs from "the market," keep in mind that this may be a sign of wise, diversified investing rather than a warning sign.

Maintaining a diversified approach and having the discipline to regularly rebalance out of your winners into the apparent losers is a roadmap to a stronger investing approach.

If you need help with your roadmap, get in touch.