We are days away from closing out the decade and what an incredible decade it has been for equity investors. Annual returns since 1957 for the S&P 500 Index averaged about 8%, with volatility around 15%; but since January 2010, equities have annualized at 13.3% with volatility at 12.5%. People often think of negative results when they think of black swans, but maybe this was an extremely positive one! Given this incredible result, I’m left questioning why to diversify at all—because clearly it didn’t do anything for you this decade.
Some investors have been diversifying using alternatives for decades, but alternatives experienced the most significant growth in assets after the Global Financial Crisis as many of the strategy types performed well in 2008 and during the ‘lost decade’ for equities, which reminded investors of the importance of diversification. But if this decade has shown us anything, it’s that diversifying using alternatives hasn’t been worth it. While the S&P 500 has returned over 13%, alternatives (HFRI Macro Index as the proxy) have annualized just over 1%. This gap is huge and it’s no wonder why the “alternatives don’t make sense” crowd is so boisterous.
But alternatives weren’t the only thing you shouldn’t have diversified into—you should have avoided non-U.S. stocks too. While U.S. stocks delivered 13.3% annualized with 12.5% standard deviation, international stocks (MSCI EAFE Index) returned 5.2% with 14.6% standard deviation, and Emerging Market stocks were even worse as they returned 3.0% with 17.1% standard deviation. If 20% of your equity allocation had been in international stocks, you would’ve lagged a traditional 60/40 portfolio by $3,615 on $10,000 invested. After this, why would anyone ever send a dollar to an overseas company, right? What is there to make us think this will change?
If we are disappointed that alternatives and non-U.S. stocks have hurt performance, then we should also be pretty upset about bonds. Over the last decade, the Bloomberg Barclays Aggregate Bond Index delivered a mere 3.8%. If you had all of your money in the S&P 500 instead, you would have had $34,620 instead of the $24,952 achieved by de-risking your portfolio with bonds. Maybe you felt better in 2018, but think about how much money you left on the table so that you could feel a little better about those few time periods over the last decade that were uncomfortable in equities? Everyone talks about risk-adjusted returns, but who really cares when it costs you this much, right?
U.S. Stock Market Broadly
While we are at it, why did you even own the entire S&P 500? I mean allegedly diversification across sectors is a good thing, but who are we kidding? It definitely didn’t do you any good to have exposure to anything outside of technology since 2010. I mean, had you just invested $10,000 in QQQ instead of the S&P 500 you would have made $10,553 more—and the standard deviation was only about 20% higher—so 30% more return for 20% more risk. And thinking ahead, why would we want to own stocks from multiple sectors when we all know that the only companies who will ever deliver value in our economy ever again will come from the Tech sector? Who can really imagine a future where tech bros with strange diet habits aren’t running the world? I can’t!
And let’s just abandon the idea of any diversification all together because if we learned anything the last 10 years, it’s that no one cares about risk-adjusted results, it’s only the return. You shouldn’t have owned bonds, non-U.S. names, alts or any stock other than Netflix for that matter. Had you just put your $10,000 in that, you would have nearly $400,000 now. Just think what diversification and thoughtful asset allocation cost you!
The Next 10 Years
It’s easy to Monday morning quarterback. I do it every single week during the Broncos season – and let me tell you, we’ve had plenty to question over the past couple years. But why is Monday morning quarterbacking so wrong? Because it is always easy to make choices when you know the outcome, and planning for the unknown is not just hard, it’s impossible. Thus, the best thing you can do is put together a strategy that has a reasonable chance of helping your clients reach their financial goals regardless of the market environment.
Do you know that at the same time ten years ago (11/30/09), the top three performing asset classes (of those referenced in this post) were alternatives, emerging markets and bonds? Stocks were down on an annualized basis just over 1% over that prior decade. Had you used those last 10 years to inform your next ten years, you wouldn’t have experienced one of the best decades for equity investing in our lifetimes, and instead you would’ve owned a portfolio of assets that were among the bottom performers as it stands now. Instead of thinking that you should stick with what worked, you would have been better off rebalancing (selling winners and buying laggards), so why wouldn’t the same logic apply now?
|10K invested in ’00 and held to 11/19||’00-’09 Return||10K invested in ’09 and held to 11/19||’10-’19 Return||10K invested in ’20 grows to|
|S&P 500 Index||$8,917.97||(1.15%)||$34,620||13.34%||?|
|MSCI EAFE Index||$11,074||1.03%||$16,547||5.21%||?|
|MSCI Emerging Market Index||$24,336.34||9.38%||$13,354||2.96%||?|
|Barclay’s US Aggregate Bond Index||$18,768||6.55%||$14,454||3.79%||?|
|HFRI Macro Index||$21,153.38||7.85%||$11,242||1.19%||?|
Like eating healthy and exercising, diversification is not the most fun or enjoyable thing you could be doing, but it is important to stay consistent. The entire philosophy around diversification means your performance will be middling. Disciplined approaches to strategic asset allocation, based on thoughtful implementation and academic reasoning, aren’t wrong unless you think that resulting is the best way to make your decisions. (Hint: It isn’t). The Seahawks chose to pass near the goal line in Super Bowl 49 instead of run. It didn’t work out and they lost the game. Clearly the best assessment of that decision (since it didn’t work out) is that Pete Carroll is incompetent, and doesn’t know anything about offensive play calling and should probably be shunned from the league forever, right? Never mind that the way the Patriots defense was lined up made the success of a run play highly unlikely. And don’t you think that if the pass would have been completed, pundits would have been praising the decision? Saying how it was tempting to run Lynch at that point, but because of the way the defense was set up, a pass was the only smart play?
None of us know what the future will bring. I mean, I predicted that the Broncos were going to the playoffs (big miss), wrote a piece at the beginning of this year about why alternatives might make sense now (another miss – for this year at least), and predicted that the final season of “Game of Thrones” would be awesome (huge miss). But since we don’t know what the future holds, all we can do is put together a well thought out and constructed portfolio that we believe will withstand whatever strange situations (good or bad), the market may throw our way. Value stocks have lagged for years—but they have very attractive valuations going forward and should likely be a part of your portfolio. Non-U.S. stocks historically go through long stretches where they ebb and flow, and you should probably own them unless you know when that change is coming. Overall, allocations to alternatives have been additive to a portfolio and may be more interesting going forward given lower expectations for traditional asset classes. While diversifying may not have felt valuable over the last decade, it is perhaps the best piece of advice you can get heading into the next one.
Join us for our upcoming webcast, Diversifying Equity Portfolios: Why it’s Vital for the Next Decade >