Beating the Market vs Trailing the Market. Why You Should Understand Tracking Error When Investing

Understanding “Tracking Error” will make you a better investor

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SPEAKERS

Anthony Saffer 0:00
Investors have different objectives, it may be beating the market. But it’s often hard to trail the market. And that’s the hard truth about investing. Investing differently is not for everybody. We’re going to talk to you today about the concept of tracking error and what you need to understand with this important concept in investing.

Anthony Saffer 0:27
Alright, so Alex, investors can measure against a number of subjective things like the Dow Jones Industrial Average, the S&P 500 index. But the truth is that the best investors have their convictions, they follow their principles, and they’re not so concerned just with the measurements.

Alex Okugawa 0:43
Absolutely. So if we think about a real-world example, you know, you almost want to think about your long-term investing strategy, as a race, and this race is a marathon, it’s not a sprint. And so while the lead may change several times throughout this race, ultimately, what matters at the end of the day, is that you’re ahead at the end of that race, you’ve paced yourself, you’ve mapped out your course, you’ve figured out your plan of attack, and you’ve gone about it in a methodical fashion.

Anthony Saffer 1:11
Yeah, so that’s a good example there. Now let’s tie it into investing and how it works with what’s called tracking error.

Alex Okugawa 1:19
So if we think about using an illustration of the market, so if we kind of think about the market, you know, the market has ups and downs, and ups and downs. And, you know, this is the broad general market, most of the time people are happy with the way that occurs. Now, if we think about, well, what does it mean to invest differently, that means there will be periods of time where you, underperform, right. And that’s what I’m circling here. And I’m just going to label a “T” is tracking error. Basically, your investments have performed differently than the overall market. And the thing to think about is that this could last months, but it could last years, it could last a decade. And so for investors, a long time might be six months. But a long time in investment circles is much longer than six months, it could be decades of underperformance to see that premium really show through.

Anthony Saffer 2:10
So it’s easy to look at a long-term chart like that and say, Well, of course, I’d hang on I’d invest, you know, according to the one that’s going to outperform the most, but as you said, the timeframe can be quite different. And it’s easy to say when there is underperformance like, Hey, we’re doing something wrong here.

Alex Okugawa 2:25
Yeah. And to give you a real-world example we’ve been seeing this in large growth companies versus small-cap stocks for you know, the better portion of a decade from now, essentially, large growth companies have outperformed smaller value companies. Now, the empirical evidence and the research show that tilting towards smaller companies on the value spectrum tends to outperform over long periods of time. But again, we’ve gone through a decade where that’s not true. So it has people wondering, is this strategy dead? Is it even worth considering? I have 10 years of underperformance. I’m out. Get me out. Get me in this large growth stuff.

Anthony Saffer 3:08
Yeah, so this type it takes discipline, it takes hanging on, and it takes really like conviction according to a plan and allowing it to play out because we know that that different asset classes do cycle.

Alex Okugawa 3:18
Absolutely.

Anthony Saffer 3:19
Well, this is the type of research-based approach that we use when putting together an investment plan and then aligning it with your overall financial plan. If you’d like to talk with us more you can go to onedegreeadvisors.com, schedule a complimentary call to talk with a Certified Financial Planner. We’d love to talk with you

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