By: Frank Armstrong
By: Frank Armstrong, III, CFP, AIFA
It’s already started. The media is full of blather that this is the worst decade for stocks ever. The corollary is that stocks have failed us and should be removed from a prudent portfolio.
Not so! Unless, of course, the investor was foolish and nave enough to invest only in US Large Companies (The S&P 500). The S&P 500 is just about the worst performing market segment on the planet. Its absurd to judge stock returns on that one index. Other parts of the worlds markets did just fine. And a portfolio diversified beyond that one market segment should show gratifying returns.
True, the S&P 500 is slightly negative for the previous ten years ending September 2009. But, the S&P 500 is only a part of the worlds stock market segments. In a properly diversified portfolio we don’t believe the S&P 500 ought to dominate the holdings. If risk and reward are related at the asset class level, then there is no reason to believe that the worlds largest most liquid, safest companies trading on the most efficient market on the planet ought to have the highest return. In fact, there is strong academic theory and real world evidence that large, mostly growth companies like the S&P 500 will have significantly lower returns than smaller and value companies.
There is also strong evidence that globally diversified portfolios will have higher returns and lower risk than domestic only portfolios. And the small and value tilt appears strong in every market where we have long term data.
Occasionally the S&P 500 will dominate all other portfolios. For instance, this was the case from 1997 to 2000. Diversified portfolios lagged in comparison. But, over the long haul diversification pays off in both higher returns and reduced risk. A diversified strategy will win more often than it loses, and cumulatively the return advantage will be significant.
At Investor Solutions we divide the worlds markets into 12 distinct asset classes: Foreign, Domestic, Emerging Markets, Real Estate both foreign and domestic, and commodities futures. In the traditional stock markets, we further divide them so as to achieve a significant tilt toward small and value companies.
All of these asset classes but one (foreign Real Estate) have been available in mutual fund format for the entire ten years. So, there is no reason that investors couldn’t have properly diversified their holdings. We held nine of the 12 for the entire period, and eleven of the twelve for over half of the period.
We all know the decade has been challenging for investors. Between the Tech Wreck, 9/11, and the near melt down of the markets in 08 we have certainly had an interesting ten years.
Here are the charts of the asset class performance expressed as compound returns for the last 5 and 10 years ending in September. You will notice a missing column on the far left where the slightly negative return of the S&P 500 should be on the ten year charts:
And here are the returns expressed as total cumulative return for the entire periods:
You don’t have to be a rocket scientist to understand that a globally diversified portfolio would have had solid returns. Even a nave division between all the available asset classes would have had respectable if unspectacular returns.
Diversification remains the primary defense against holding all your equities in the worlds worst market segment. Sophisticated investors will want the full measure of diversification.
So, I hope I don’t have to listen to too many more stories about the death of stocks, or how stocks failed us. Its just not so!