Bronfman Rothschild 2018 3rd Quarter Review: “The Taming of the Diversified Portfolio”
The concept we discuss here goes back to before the advent of the written word, living in parables echoed in religious and secular texts alike. The precise wording has evolved, but the message has not changed materially over time. Cervantes put it on paper more than 400 years ago through the lips of Sancho Panza, and we still use a translated version of it to teach our kids: “It is the part of a wise man to keep himself to-day for to-morrow, and not to venture all his eggs in one basket.” To be more succinct, diversify. Investors have leaned on this idea for a long time, and diversification is often heralded as the “only free lunch in investing.”
Translated into simple terms, the addition of less correlated assets to a portfolio reduces the portfolio’s risk while potentially improving expected returns. But, diversification has fallen short in recent years, leading to declarations that it is an antiquated concept with little applicability in the modern world. This year the S&P 500 Index finished the first three quarters up more than 10%. A portfolio with a 60% allocation to global equities and 40% to investment grade bonds returned less than 2% over the same period. The wide difference in performance between large cap U.S. equities and a globally diversified portfolio has come after a series of equally disappointing years. Is it time to declare diversification dead?
Investors need to remember why they initially sought a diversified portfolio. It will never be the best performing asset in the world, just as it will never be the worst performing asset in the world. The last recession and subsequent major bear market are key examples of why this is relevant. When investors looked back at 2008, very few credibly predicted the severity with which equity markets declined. From the market peak in October 2007 to the bottom in March 2009, the S&P 500 Index lost more than 50%. Investors with a 60/40 portfolio also lost money in that time, but as the markets began to rebound, given the deeper hole, it took significantly longer for equity markets to recover than a diversified portfolio. The lost decade of 2000-2010 provides the flip side of what we have seen recently. Over that 10 year period the S&P 500 Index lost a cumulative 9%, while international stocks rose 37%, commodities returned 51%, and investment grade bonds put up an astounding 85%.
We discussed a few of the most common behavioral biases last quarter and they speak to why investors struggle with a truly diversified portfolio.
- Loss aversion states that investors are more sensitive to losses than to gains, by a ratio of 2:1. Within a diversified portfolio, it should be expected that an asset somewhere in your portfolio is losing money at a given point in time. If that is not the case, are you truly diversified?
- We mentioned the home country bias exhibited by most investors, whereby the familiarity of a local stock market falsely builds investor comfort equating to a belief that market has lower risk. We are not alone in this approach. According to a recent study, Australians hold nearly 75% of their portfolios in Australian issues. Canadians hold 65% in Canada.
- Lastly, recency bias causes investors to more prominently recall and emphasize recent performance over that in the distant past, oftentimes extrapolating latest performance into the foreseeable future. A portfolio that owns different asset classes will have overachievers, naturally causing investors to wonder why they do not own more of that asset.
Investors should carefully consider their own susceptibility to recency bias in stock markets. After technology stocks peaked in 2000, they lost 80% and took more than 17 years to return to that prior peak. Only now, after another impressive run, are investors eagerly looking to return to those stocks. How many investors were proactively buying technology stocks prior to this run up? Similarly, despite the weak recent performance in emerging economy stocks, they remain the top performer over the last 15 years ending 2017.
It is helpful to look at our portfolios since the global financial crisis and wonder what could we have done differently? The answer will never be to chase yesterday’s winners. When we discuss diversified portfolios, it is done with the benefit of many years of data and evidence suggesting that a balanced approach helps minimize the highs and lows associated with investing.
We discussed trade rhetoric being a volatility catalyst for markets earlier in the year and while the headlines remained the same, domestic equity markets seemed more focused on earnings in the third quarter. The U.S and China continued to squabble, but domestic large cap stocks were up 7.7% and small cap gained 4.7%. As we also noted previously, growth stocks have been well ahead of value stocks and that phenomenon did not ease last quarter. Apple and Amazon pushed to new all-time highs and were significant contributors to the outperformance of growth.
It is worth noting that the U.S. experience was distinct from the rest of the world. International stocks rose a modest 0.4%, while emerging markets remained under stress and lost 1.5%. The drop in EM stocks was blamed on any number of country-specific events, but with China accounting for 30% of the index and Chinese stocks losing money every month this quarter, it was unlikely the broader index could overcome that pressure.
In fixed income, interest rates continued to climb ever so gradually. The Barclays Aggregate Bond Index was flat this quarter but remains down 1.6% for the year. At the end of September, the Federal Reserve hiked interest rates for the third time this year and the Committee indicated that one more hike is likely before year-end, along with three more hikes in 2019. If those expectations are met, overnight interest rates could reach 3% next year for the first since the beginning of 2008.
The universe of alternative assets had an uneventful quarter. MLPs were a positive standout, but infrastructure and REITs were little changed. Commodities lost money because of noticeable weakness in the agricultural complex and metals. Hedged equity funds (represented by the HFRX Equity Hedge Index) declined, as they tended to carry a value bias in a period where growth outperformed.
The S&P 500 Index lost 3.3% on October 10th, and another 2.1% on the 11th. These returns were the worst single-day losses since the Index lost 2.2% on April 6th. But even before that, the Index lost 2.2% on April 2nd, 2.1% on March 23rd, 2.5% the day before on March 22nd, 3.8% on February 8th, and 4.1% on February 5th. In fact, on average, since 1929 (admittedly, not a great year) there have been between three and four days a year when the S&P 500 Index loses more than 3%. It not only happens, it is unusual when it does not.
And to avoid being too dour and provide a more balanced context, realize that the S&P 500 Index also has, on average, roughly three days a year that it earns more than 3%, so all is not lost!
- During the 30 years ending 9/30/18, the best 12-month performance and the worst 12-month performance for the S&P 500 Index occurred over a single 24-month period. The worst 12-months (a total return loss of 43.3%) was the 1-year from 3/01/08 to 2/28/09 and the best 12-months (a total return gain of +53.6%) was the 1-year from 3/01/09 to 2/28/10.” (Source: BTN Research, mahbtn).
- America’s 5 largest banks control 47% of all banking assets, up from 29% in 1998 or 20 years ago (source: Federal Reserve Bank of St. Louis, mahbtn).
- After adjusting for inflation, the median household income in 2017 ($61,372) is the highest ever recorded in the United States, besting the previous record for median household income ($60,309) set just the year before in 2016. Before 2016, the peak for median household income was $60,062 set in 1999 (source: Federal Reserve Bank of St. Louis, mahbtn).
- An estimated 44.4% of all US individual taxpayers will legally pay zero federal income tax for tax year 2018 on their Tax Form 1040 that is due 4/15/19 (source: Tax Policy Center, mahbtn).
- Apple’s $1 trillion market capitalization is larger than the combined stock markets of Russia and Mexico.