We don’t have to be smarter than the rest, we have to be more disciplined than the rest.
-Warren Buffet
Over our many decades offering investment advice, we’ve inherited many more portfolios that had investor problems than investors who had portfolio problems
–Fusion Family Wealth
Many investors, particularly prospective investors who interviewed Fusion in the latter part of 2018, expressed their concern that, “global diversification wasn’t great for investors this year.” We learned that those investors didn’t understand the purpose of diversification and didn’t appreciate how much of a benefit diversification would yield over their investment horizons, often spanning 25+ years through retirement.
Asset allocation is the process of combining, in one portfolio, the three major asset classes (stocks, bonds and cash). Within the stock asset class, diversification divides the invested stock assets among portfolios by style (value vs. growth), capitalization (small vs. large companies) and geography (U.S., International and emerging markets); all of which have historically run on different cycles (annually, each one randomly performs better or worse than the others). A portfolio with obvious “winners” and obvious “losers” every year is evidence of a genuinely well diversified portfolio. True equity diversification will always mute the return of a total portfolio at any given moment — as it has done this year. However, the benefit is that diversification enables the investor to capture the full annualized return of all of the components over their entire investment life.
Was 2018 a bad year for a globally diversified portfolio?
As of November 21, the best performing stock component – the Nasdaq 100, U.S. technology heavy index – gained 2%, while the least performing stock component – the emerging markets index – declined 14%. A globally diversified portfolio1 declined 5%.
What about the past?
For the 15 years ending in 2017, emerging markets spent 1/3 of the period in negative
territory. They declined 54% in 2008 (S & P was down 36%), they declined 19% in 2011 (S & P was up 2.6%) and they declined 13% in 2015 (the S & P was up 2%). The 15 year annualized return for the S & P was 9.7% per year and for the emerging markets it was 13.1% per year.2 For just these 15 years, $100,000 invested in the S & P turned into $400,000. The same amount invested in emerging markets turned into $634,000. In fact, from 1988 (the earliest year for which there is emerging market performance data) through 2017, emerging markets was the best performer by an even larger margin, returning 16.3% per year versus the S & P return of 12.2% per year.3 Over this 30 year period, which is more reflective of an investor’s retirement horizon, $100,000 grew to just over $3 million in the S & P versus over $9 million in the emerging markets. Investors were very well compensated for emerging markets’ increased up and down movements. Eliminating the emerging markets has been – and most probably will continue to be – an extremely costly mistake.
The last thing any rational investor would do is to sell a portfolio component that is already down to buy the component that is already up. This behavior would destroy diversification and is actually speculation on the continuation of short- and intermediate-term trends. It is one of the worst forms of performance chasing. Yet, this is exactly what the overwhelming majority of investors either do or want to do. This applies equally to wealthy investors (there is no correlation between ones wealth and investment “sophistication”) young ones, old ones, ones with advanced finance/business degrees, etc…). They are all bound by one thing — the immutability of human nature and human nature is always a failed investor. Each one of these investors is no less likely than the other to abandon a diversified portfolio in 1999 to chase every telecom, dot com and internet stock – often on margin! Nor is each investor less likely than the other to sell an entire diversified stock portfolio in January 2009 to go to cash in uncontrollable panic!
Our temperament, rather than what goes on inside our portfolios is almost always the dominant cause for failing to meet our financial goals. In our many decades as advisors, we have seen substantially more portfolios that have investor problems than investors that have portfolio problems.
By having a diversified portfolio that is periodically rebalanced, we know that we will have a bunch of whatever “outperforms” next. Rebalancing is the closest thing an investor has to a free lunch. It forces us to trim from what has gotten relatively expensive and use the proceeds to add to what has gotten relatively cheap. This is the opposite of what human nature wants to do.
One of the main reasons that human nature is a failed investor is cultural.
Human nature responds to economic and financial inputs counter-cyclically. When the price of something we want is high and rising, we are repelled by it. Conversely, when the price of something we want is low and falling, we want to buy more of it. This is rational. Human nature responds this way to all economic and financial inputs except one thing – stocks!
When the price of stocks is high and rising (i.e., technology, telecoms and dot coms in 1999 like AOL, Cisco, Lucent, JDS Uniphase, Worldcom, etc…) human nature thinks that the value is rising and the risk is declining. When the price of stocks is low and falling (i.e., 2008-2009) human nature thinks the value is falling and the risk is increasing. The reality is not
different than what human nature thinks, it’s the opposite! Human nature wants out of the thing that’s down and wants to put it in the thing that’s up.
So, to the investor who believes 2018 wasn’t a great year for global diversification, I say – from a financial perspective — globally diversified investors neverhave great years, they have great lives!
Remember that there is not one historical example where a quality portfolio consisting of many companies (S & P 500, for example) has had any decline that wasn’t temporary. Declines are temporary and the increase (in price and dividends) is permanent. Volatility is not risk any more than temporary decline is permanent loss!
To those who are comfortable that they are genuinely diversified, give thanks for that realization! For those who find they are not, you may be thankful for this information.
Happy Thanksgiving to all our clients and friends from your Fusion Family!
- Refers to a blend composed of 65% Russell 3000 TR, 35% FTSE Global All Cap Ex US Index (USD).
- 15 year performance ending in 2017 provided by Morningstar.
- Emerging market performance from 1998 through 2017 provided by ETF.com.
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Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Fusion Family Wealth, LLC (“Fusion”), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Fusion. Please remember to contact Fusion, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Fusion shall continue to rely on the accuracy of information that you have provided. Fusion is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Fusion’s current written disclosure brochure discussing our advisory services and fees continues to remain available upon request.