a) Using momentum are often guilty of chasing performance. In fact, momentum requires that we do this. But it should be done in a disciplined and systematic way
b) It is not always easy adhering to a disciplined approach. If you are not vigilant, emotions can get the better of you. Even Daniel Kahneman, the father of behavioral economics, admits to being influenced by behavioral heuristics.
c) First BIG MISTAKE - MYOPIA - Those who look at performance frequently do not do as well as those who are less concerned with short-term performance. It is important to keep the big picture in mind. We should wait for at least a full bull and bear market cycle before evaluating the performance.
d) Second Big Mistake - Accepting Lower Risk Premia - We should invest in a way that offers us the highest expected return while limiting our risk exposure. Limiting downside exposure is important so we do not panic under stress and do stupid things. Many have tried to use broad diversification to reduce their portfolios’ draw down exposure.
If you select non-correlated assets, you can achieve some reduction in volatility and draw down. That is where the problem lies. Assets with lower expected returns will reduce your portfolio’s return.
Bonds have done well over the past 15 years. But longer term, their real return is less than one-third the real return of stocks.
Bonds are also not as low-risk as you might think. Since 1900, the worst real return draw-down was 73% for stocks and 68% for bonds. Stocks and bonds can sometimes have severe draw-downs simultaneously.
e) THIRD MISTAKE - Not Using Geographic Diversification and Preference for Complexity - Investors and advisors seem to prefer complexity over simplicity. Many believe that elaborate models and more diversified portfolios perform better than simpler approaches.
f) FOURTH MISTAKE - Non-Optimal Portfolio Construction - Some portfolios suffer because investors rely on well-known measures like the Sharpe ratio for selecting assets. The Sharpe ratio divides excess returns by the standard deviation of those returns. It is an efficiency measure telling you how much return you might expect per unit of volatility. But unless returns are normally distributed (they almost never are), the Sharpe ratio is not a good indicator of downside risk.
You can increase the Sharpe ratio of most portfolios by simply adding more bonds. But your expected rate of return and accumulated wealth will in most cases suffer.
If two strategies have the same average return, the one with lower volatility will have a higher CAGR.
But like the Sharpe ratio, CAGR does not measure tail risk.
Extreme downside exposure can cause you to exit positions prematurely screaming in pain or cursing your investment advisor. That is why its important to also consider draw-downs.
Worst draw-down is only a single point in time, but it can give you a pretty good idea about tail risk. Also examine the distribution of returns and look at rolling windows of draw-downs.