Innovation Has No Bounds

Sometimes clients question whether the market can keep going up from here.  The S&P 500 hit an all-time high yesterday and I get more questions from clients on whether this can continue versus how high it can go.  This skepticism is not unfounded.  In the past 15 years we’ve experienced two bear markets that erased 50% of stock portfolios so you can understand why investors might be a little bit skittish.  But there is an important point in all of this that we all must realize:  markets work.  Companies take raw materials, labor and ideas and turn them into something that is greater than the sum of their parts.  This has been evident throughout time and ingenuity doesn’t just stop because people are worried about stock valuations, employment or the direction of our economy.

Case in point, many of you may have heard that Google is working on a self-driving car.  Here is a link to more info on this innovation.  Think about the possibilities if something like this takes off.  Cars being able to go 100 mph without risk of accident.  Being able to sleep or work during travel will make everyone more productive.  This just scratches the surface of what innovation will be able to accomplish in fields like medicine, energy and computing.  For those who are uncertain about the future, I would encourage you to realize that uncertainty is normal, but so is innovation.  This ingenuity will allow companies to create new products and greater profits in the years and decades to come.

Don’t Just Do Something, Stand There!

We have often cited research explaining the problem investors have managing their money.  It is almost always self-imposed, caused by one of two emotions:  fear or greed.  Investors have historically bought and sold at inopportune times doing the opposite of “buy low and sell high”.  It is understandable.  Investing is an emotional experience and those who are most emotional tend to lose.  Vanguard has taken data compiled by Morningstar to show how much damage we have done to ourselves over a 15 year period:

 

What this shows is that our behavior is causing us to trail the returns of our funds between 0-3.5% per year.  Typically, the more volatile the asset class, the worse our performance.  This gap is caused by buying and selling at the wrong time.  Had we just bought and hold we could have generated returns 0-3.5% higher than we actually experienced.

It is important to remember this chart when you are thinking about making a portfolio change.  While no one will know if the change is going to add or detract value, the data shows that it is more likely to detract which should cause you to think hard about making changes.

How Much Of My Stock Portfolio Should Be In Foreign Companies?

Yesterday, we wrote about the value of adding foreign stocks to a portfolio.  The next question we wanted to answer was how much of your portfolio should be in foreign stocks.  Unfortunately, there isn’t a right answer to the question.  It is probably more art that science, but we do think there are some key points investors should be aware of.  

  • The US Market represents about 40% of the total market capitalization of the world.  This is a good starting point to determine how much of your portfolio should be in US versus foreign stocks.
  • Our own research shows that adding foreign stocks to an all US stock portfolio brings down the risk of the total portfolio, so we recommend that most clients have at least 30% of their equities in foreign stocks

If the US market makes up 40% of the total world stock market, why would we advocate having 60 or 70% of our client’s portfolio in US equities?  There is good reason for this “home country bias” that investors should consider when designing their portfolio:

  • Fees for US equity funds are less than foreign equity funds.  According to Morningstar, the average expense of a US Large Blend Fund is 0.48%, Foreign Large Blend is 0.74% and Emerging Markets is 1.10%.
  • Trading costs are lower.  One study found that trading costs for US Equity funds averaged 0.36%, Foreign funds 0.45% and Emerging market funds were 0.61%.
  • Behavioral- when investors significantly weight foreign stocks in a portfolio there can be more of a tendency to tweak the portfolio over time since there will be many years with significant underperformance to indices like the S&P 500.  Since most of us tend to compare our portfolio to the market we see on TV or on the internet (like the Dow Jones or S&P 500), we must ask ourselves the question whether we would feel comfortable significantly trailing the US market during some years.  I have found that the more a client deviates from their perceived “home market” the higher the possibility for tinkering with the portfolio.

For all these reasons, most clients would be well served by keeping a larger portion of their equities in US stocks.

Do Foreign Stocks Add Value In A Portfolio?

With the US stock market generating substantial gains over the past several years, many investors are questioning why they should have exposure to foreign stocks in their portfolio.  Over the past 3 years (ending 4/30/14), the MSCI World Index (ex-US) has averaged 5.0% per year while the S&P 500 has gained 13.8% per year, so you can see why investors may be questioning a strategy of diversification.  We must go back longer (over multiple periods) to really see why diversification can add value:

                                                   S&P 500         MSCI World (ex-US)

  • 1970-1980                   5.9%                     9.6%
  • 1980-1990                   17.6%                  20.7%
  • 1990-2000                  18.2%                   7.1%
  • 2000-2010                  -1.0%                   1.6%
  • 2010-4/2014              15.3%                   7.7%

In addition, since 1970 foreign stocks have outperformed US stocks in 54% of all rolling 10 year periods.  Abandoning an asset class just because it has not performed well recently is a bad strategy, especially when you look a the historical data showing the value this asset class can add to a portfolio.  

If you believe that foreign stocks should remain a fixture in a portfolio, the next question logically is how much?  We’ll dive into that question in a future blog post.

Questioning The Need For Hedge Funds

We have continued to question investor’s decisions to own hedge funds in their portfolio for some time.  The costs are high and the idea that a manager will be able to consistently outperform using a specific strategy flies in the face of most research on the subject.  Bianco Research put out this piece showing how an investment in an average hedge fund has done compared to the S&P 500.  

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This particular index tracks long/short funds.  These managers attempt to buy all of the good companies and sell short the companies they believe will underperform.  In all fairness, these funds are much less risky than a stock index, so it is hard to compare apples to apples here.  With that being said, the underperformance has been tremendous.  For most investors, if they want to reduce risk, they should look at purchasing a bond fund versus using hedge funds, which have a lackluster track record at best.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.