Diversified and Steady Wins the Race
Photo by Mika Baumeister on Unsplash
Higher inflation and market volatility have suddenly changed investors’ perceptions of risk and uncertainty. Many may be thinking now is the time to get out of the market. However, historical evidence suggests that we can’t predict where the market is going, and you can miss out on large returns if you are not consistently invested and fail to time the market. Many investors learned this lesson the hard way at the onset of the pandemic. In addition, not all investments react to economic events in the same way and at the same time. Having a broadly diversified portfolio across different types of stocks and bonds across many countries can help smooth out the effects of uncertainty about particular markets. Inflation protection and a goals-based allocation can improve the risk management side of your portfolio.
Lessons from the lost decade
A great example that illustrates the benefits of staying invested and having a diversified portfolio is the decade between January 2000 and December 2009. This is the so-called lost decade, as the stock market had negative cumulative returns. If you invested $100,000 in the S&P 500 at the beginning of the decade, you’d end up with about $91,000 after 10 years of staying invested.
The media and, too often, investors focus on headline indices like the S&P 500 and the Dow Jones to measure performance. However, a well-diversified portfolio won’t be 100% invested in the S&P 500. Investors have low-cost access to more than 13,000 stocks across well over 40 countries versus the 500 US stocks of the S&P 500. Following good advice, investors will also include a well-diversified bond portfolio of government and corporate bonds. So a good question for today’s investors concerned with low potential upside is this: What would have been the performance of a balanced and well diversified portfolio during the “lost decade”?
The figure below shows the growth of a dollar invested in the S&P 500 (grey line) and, for reference, the growth of a dollar invested in T-bills over the same period (light blue line). The S&P 500 underperformed T-Bills in this period. However, consider the dark blue line. This line represents the growth of a dollar invested in a more diversified 50/50 stocks/bond portfolio: 25% is invested in the S&P 500, 25% invested in international stocks (measured by the MSCI ACWI index ex-US), and the remaining 50% invested in US government and corporate bonds of intermediate maturity (measured by the Bloomberg Barclay Govt and Corporate Bond Index Intermediate). [A similar comparison was reported by Ron Lieber, “Steady Savers Still Came Out Ahead” The New York Times, Jan 1, 2010]
Growth of a dollar during the lost decade
Notes: For illustration only. You cannot invest in an index directly. Actual returns would be transaction costs and taxes. T-bills is the return on one month T-bills, Global 50/50 is invested 25% in S&P 500, 25% in MSCI ACWI ex-US, 50% in Bloomberg Barclays Govt and Corporate Intermediate bond index. Data from Dimensional Fund Advisors.
With a balanced, globally diversified portfolio, an investor with $100,000 at the beginning of the period would have ended up with approximately $155,000 dollars at the end of the period. That’s an annualized return of 4.5%. This return is below the historical average for a balanced portfolio, which is closer to 7%, but it is hardly evidence of a lost decade for investors.
Further, consider someone investing monthly at the rate of $1,000 per month in the globally diversified 50/50 portfolio, perhaps an investor saving in their 401(k) account. The value of the total contributions at the end of the 10 years would grow to approximately $150,000, $30,000 more than the investor put in. An investor with this saving schedule that started the decade with $100,000 would end up the decade with $305,000. Diversified and steady wins the race.
Advanced Diversification
Both the S&P and the MSCI indexes chosen above focus on large stocks. For example, there are about 4,000 stocks traded in the US stock exchange, most of them of smaller companies than the 500 companies included in the S&P 500. Further, both indexes are market-weighted indexes and, as a result, they tend to focus on the larger of the large companies. However, data by professor Ken French at Dartmouth College shows that smaller companies outperformed larger companies during the “lost decade”, and so did value companies. During the 2000-2009 decade, a diversified portfolio that emphasized smaller companies and value companies would have done even better than the global portfolio in our illustration.
This is relevant today because the relatively high valuation of today’s US stock market is driven by the exceptional outperformance of a group of growth companies with low profits. Companies with good profitability and low prices relative to their earnings, what we traditionally call “value companies,” have relatively low valuations. Similarly, many countries outside the US have much lower relative valuations than in the US.
The Randomness of Returns
Here is the main lesson from the lost decade. If you are concerned with potentially low returns given current valuations and the heightened uncertainty, having a broadly diversified portfolio across stocks and bonds and saving diligently are your best boat to navigate future uncertainty. Different markets and industries across the globe will react differently to different economic developments. While that won’t necessarily make your ride smooth, it will make it smoother, and more likely going up. Consider the following illustration from Dimensional Fund Advisors. It shows the relative performance, from highest to lowest, of different markets. Each year, the ranking of the different investment categories in the figure varies unpredictably.
Source: Dimensional Fund Advisors. The chart is for illustrative purposes only and does not represent investment advice.
Yes, it would be great if we could just pick the winning investment type in every situation But we can’t. A more useful reading of this picture is that historically, different asset classes have generated different relative returns, year over year. A broadly diversified portfolio that includes all of them can help you smooth the ride and earn you average returns across all of the investment types, without missing valuable investment opportunities.
Economic Uncertainty and Your Portfolio
One key source of uncertainty currently is rising inflation. Consider first where you are in the lifecycle. If you are accumulating (preretirement), you have some inflation hedge through your income, which typically rises with inflation, and your stock investments, which tends to outpace inflation over long periods of time. If you are close to retirement or are retired, consider protecting the purchasing power of your savings by investing in short to intermediate, inflation-protected bonds. These are bonds whose payments adjust with inflation. You can find inflation-linked bond mutual funds and ETFs that invest in Treasury inflation-protected securities or TIPS, while others invest in corporate bonds or municipal bonds. In the case of corporate and muni bonds, the underlying bonds are not inflation-protected, but the return on the funds are.
If you are concerned with the prospect of a geo-political sell-off, our initial advice of staying invested and being diversified still applies. Research by Vanguard shows that these sell-offs are typically short-lived, at least if geographically contained. However, if uncertainty and the market volatility is worrying you, consider evaluating your personal preference for risk-taking, and align your portfolio risk to your goals.
Uncertainty is part of investing. As we have discussed in previous posts, sailing through uncertainty requires you to stick with your investment philosophy. Time in the market and maximum diversification should be two fundamental principles of any investment philosophy. Today, investors have the ability to invest in globally diversified stocks, bonds, and real estate portfolios at a very low cost. So start with a broadly diversified portfolio suited to your risk characteristics when deciding how to invest, and stick with it!
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
