“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” – John Maynard Keynes
In my previous blog, I showed the dismal expected returns for U.S. Treasury bonds and large-cap American stocks over the next seven to ten years. Your typical American investor with a 60% stock/40% bond portfolio is staring down the barrel of potentially devastating returns – ~2.5% a year above inflation compared to ~5.0% a year real returns they’ve earned historically.
Naturally, this leads to the obvious question: What can we do about it?
Well, you could spend less, save more and delay retirement for a couple of years. This would solve the problem for most people. However, from an investment perspective, you can also take some steps that could help improve your returns.
Look Abroad
While U.S. stocks look pretty expensive relative to history, international developed stocks and emerging markets stocks appear reasonably priced. Here’s the breakdown of expected annual real returns for stocks over the next seven to ten years:
U.S. stocks 4.0%
International Developed 5.5%
Emerging Markets 7.0%
As you can see, valuations point to much better returns for international stocks. Sadly, valuations aren’t saying that international stocks are poised for great returns. In fact, they look quite average from a historical perspective; it’s just that they look good compared to the paltry expected returns on U.S. stocks.
Factor Diversification
For those not familiar with “Factor Diversification,” please take a look at my articles here, here and here. Simply put, factors are characteristics that tend to add a premium (additional return) to the underlying stock. Two of the most studied are the Small and Value premiums. Stocks with these attributes have historically outperformed the S&P 500. How much?
January 1928 to June 2016 annual nominal returns*
S&P 500 9.7%
U.S. Large Value Stocks 11.1%
U.S. Small Stocks 12.0%
As you can see, owning value stock would have increased your returns by 1.4% a year, while owning small stocks would have increased returns by 2.3% a year. Unfortunately, factor investing has become more popular with institutional investors, so let’s estimate that going forward the value and small premiums will be worth ~1.0% a year each.
Putting It All Together
Armed with this knowledge, let’s look at a portfolio that’s globally and factor diversified:
Allocation Expected Return
15% S&P 500 4.0%
15% U.S. Small Value 6.0%
10% Large International Developed Stocks 5.5%
10% International Developed Small Value Stocks 7.5%
10% Emerging Markets Value Stocks 8.0%
40% U.S. Treasury Bonds 0.0%
If you do the math, you’d find that this portfolio is estimated to earn 3.6% annual real return, possibly a touch more due to rebalancing. (Incorporating another factor known as Momentum also likely would improve returns.) Now, that’s still below the historic 5.0% annual real return, but it’s far better than the 2.4% annual real return that we started with.
Why Doesn’t Everybody Do It
Ok, it’s seems like a no-brainer. Add international developed stocks, emerging market stocks, value stocks and small stocks to the stock portion of your portfolio and you likely will help boost your returns while adding diversification, which is always a good thing.
This begs the next question: If this is so obvious, why doesn’t everybody do it?
In a word: Psychology.
To quote Warren Buffet, “Investing is simple but not easy.” Everybody loves the “idea” of being diversified but finds the reality of owning stocks that go up and, particularly, down at different times than the S&P 500 extraordinarily painful.
For example, the S&P 500 has demolished international developed and emerging market stocks for the past FIVE years. If that’s not bad enough, the value premium and small premiums have both been NEGATIVE over that same period. Let’s look at what a $1,000 invested in each asset would have grown to over the past five years**:
S&P 500 $1,770
U.S. Large Value Stocks $1,691
U.S. Small Stocks $1,605
International Developed Stocks $1,009
Emerging Market Stocks $985
Look at those international numbers again. You would have endured political turmoil and wild gyrations in stock values for five years just to be more or less flat, while American stocks soared. Most people can’t handle it. The pain becomes too much, and they bail out on their international stocks. The same thing happens with owning small and value stocks when they have long periods of dramatic under performance compared to the S&P 500.
Having a well-diversified portfolio works in the long run (think 10 to 15 years), but our minds don’t operate that way. If you install a washing machine, and it doesn’t work, you don’t wait 15 years to see if it will come around. You get rid of it. The same goes for employees. If you have an employee who has been terrible at their job for the past five years, you fire the person. And rightfully so! They are never going to get better.
But that’s not how investing works. Successful investing is a form of psychological torture, and your only defense is understanding why diversification works and knowing the history of asset returns, which prepares you for the long stretches (sometimes lasting longer than a decade) of under performance that eventually hit all assets.
So, yes, all the evidence (both academic research and live mutual fund returns) shows that a globally, factor diversified portfolio is the best option. In addition, valuations strongly suggest that this type of portfolio could be particularly useful over the next decade.
However, history also shows that unless you have a very good understanding of why a globally, factor diversified portfolio works, the odds are extremely high that you will not stick to the plan, in which case, you would have been better off staying with American stocks and accepting the expected lower returns.
My best advice is to prepare for lower returns and to get the education needed to adopt a globally, factor diversified portfolio.
*Based on Prof. Ken French’s Princeton database, using Large Value Index and Small Cap Index.
**Funds and indexes used are S&P 500 index, DFA Large Value fund, DFA Micro Cap fund, MSCI EAFE Index and DFA Emerging Markets Portfolio
Mark on Money 