McCartney Wealth Management
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“The irresistible urge to seek patterns can get us into serious trouble when we take this tendency to the field of finance and investing. So, as investors, it’s important to know that we’re dealing with something where randomness and chance can distort the expected outcome in the short term.”
Vishal Khandelwal

“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”
John Kenneth Galbraith

“The high volatility of stock returns is common knowledge, but many investors may not fully appreciate the implications of return volatility. Investors cannot draw strong inferences about expected returns from three, five, or even ten years of realized returns. Those who act on such noisy evidence should reconsider their approach.”
Eugene Fama and Kenneth French

Markets.

Equity markets around the world posted strong negative returns for the quarter and calendar year. Below are the indices we follow.

Periodic Performance
By 12/2018; Default Currency: USD
3 Months 1 Year 3 Years 5 Years 10 Years
S&P 500 -13.52 -4.38 9.26 8.49 13.12
Russell 2000 -20.20 -11.01 7.36 4.41 11.97
Russell 2000 Value -18.67 -12.86 7.37 3.61 10.40
MSCI World ex USA (net div) -12.78 -14.09 3.11 0.34 6.24
MSCI World ex USA Small Cap (net div) -16.16 -18.07 3.85 2.25 10.06
MSCI Emerging Markets (net div) -7.47 -14.58 9.25 1.65 8.02
Bloomberg Barclays U.S. T Bond 1-5 1.75 1.51 1.07 1.06 1.33
ICE BofAML 1-Year US T Note 0.78 1.86 1.06 0.70 0.62

Although painful, such returns are not abnormal, as Fama and French allude to above.  The S&P 500 is negative almost 25% of the time in any given calendar year since 1926 as shown by the chart below.  Further, the standard deviation (a measure of how much actual returns have varied from the average) of the S&P 500 is almost twice as much as its long term average.

In addition, both value stocks and international stocks have underperformed recently.  We get questions on whether we should avoid such asset classes in favor of large US stocks.  However, as memories are indeed short, I would like to remind investors of the dismal performance that US stocks had from 2000-2009.  As our friends at Dimensional point out below, there are definite benefits to diversification, although it may not feel like it in the short term.

Dimensional Fund Advisors on Why Should You Diversify?

For the five-year period ending October 31, 2018, the S&P 500 Index had an annualized return of 11.34% while the MSCI World ex USA Index returned 1.86%, and the MSCI Emerging Markets Index returned 0.78%. As US stocks have outperformed international and emerging markets stocks over the last several years, some investors might be reconsidering the benefits of investing outside the US.

While there are many reasons why a US-based investor may prefer a degree of home bias in their equity allocation, using return differences over a relatively short period as the sole input into this decision may result in missing opportunities that the global markets offer. While international and emerging markets stocks have delivered disappointing returns relative to the US over the last few years, it is important to remember that:

  • Non-US stocks help provide valuable diversification benefits.
  • Recent performance is not a reliable indicator of future returns.

 

THERE’S A WORLD OF OPPORTUNITIES IN EQUITIES

The global equity market is large and represents a world of investment opportunities. As shown in Exhibit 1, nearly half of the investment opportunities in global equity markets lie outside the US. Non-US stocks, including developed and emerging markets, account for 48% of world market capitalization¹ and represent thousands of companies in countries all over the world. A portfolio investing solely within the US would not be exposed to the performance of those markets.

THE LOST DECADE

We can examine the potential opportunity cost associated with failing to diversify globally by reflecting on the period in global markets from 2000–2009. During this period, often called the “lost decade” by US investors, the S&P 500 Index recorded its worst ever 10-year performance with a total cumulative return of –9.1%. However, looking beyond US large cap equities, conditions were more favorable for global equity investors as most equity asset classes outside the US generated positive returns over the course of the decade. (See Exhibit 2.) Expanding beyond this period and looking at performance for each of the 11 decades starting in 1900 and ending in 2010, the US market outperformed the world market in five decades and underperformed in the other six.² This further reinforces why an investor pursuing the equity premium should consider a global allocation. By holding a globally diversified portfolio, investors are positioned to capture returns wherever they occur.

PICK A COUNTRY?

Are there systematic ways to identify which countries will outperform others in advance? Exhibit 3 illustrates the randomness in country equity market rankings (from highest to lowest) for 22 different developed market countries over the past 20 years. This graphic conveys how difficult it would be to execute a strategy that relies on picking the best country and the resulting importance of diversification.

In addition, concentrating a portfolio in any one country can expose investors to large variations in returns. The difference between the best- and worst‑performing countries can be significant. For example, since 1998, the average return of the best‑performing developed market country was approximately 44%, while the average return of the worst-performing country was approximately –16%. Diversification means an investor’s portfolio is unlikely to be the best or worst performing relative to any individual country, but diversification also provides a means to achieve a more consistent outcome and more importantly helps reduce and manage catastrophic losses that can be associated with investing in just a small number of stocks or a single country.

A DIVERSIFIED APPROACH

Over long periods of time, investors may benefit from consistent exposure in their portfolios to both US and non‑US equities. While both asset classes offer the potential to earn positive expected returns in the long run, they may perform quite differently over short periods. While the performance of different countries and asset classes will vary over time, there is no reliable evidence that this performance can be predicted in advance. An approach to equity investing that uses the global opportunity set available to investors can provide diversification benefits as well as potentially higher expected returns.

Exhibit 3. Equity Returns of Developed Markets

Investing is complex and can be scary. The best way to achieve long-term success is to:

  • Create an investment plan to fit your needs and risk tolerance
  • Structure a portfolio to capture dimensions of expected returns
  • Diversify globally
  • Manage expenses, turnover and taxes
  • tay disciplined through market dips and swings.

We know day to day volatility of markets can cause anxiety. To get long-term returns, investors must endure both volatility and negative returns periodically. As you can see, it is definitely not a straight line.

Please call if you would like to set up a meeting to discuss your investments and plan.

Best,

Mike and Emily

Source: Dimensional Fund Advisors LP.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.

There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their financial advisor prior to making any investment decision.

1. The total market value of a company’s outstanding shares, computed as price times shares outstanding.
2. Source: Annual country index return data from the Dimson-Marsh-Staunton (DMS) Global Returns Data, provided by Morningstar, Inc