We just completed the second consecutive year where U.S. large-cap stocks outperformed most other asset classes, including U.S. small stocks, U.S. value stocks and international stocks. This development has led some investors to wonder whether diversification still works. We believe diversification should remain an essential part of a well-devised, long-term investment plan, and that investors should resist the temptation to re-allocate their portfolios toward strategies with high recent performance. Research shows that basing a current investment strategy on past performance typically leads to poor future performance because of the difficulty of successfully timing markets.
A REVIEW OF 2015
Figure 1 reports the 2015 performance of various equity asset classes.
Figure 1: Asset Class Returns in 2015
As Figure 1 shows, U.S. large-cap stocks (using the S&P 500 as a proxy) had substantially higher returns in 2015 than most other equity asset classes. This performance is at odds with longer-term historical returns data, which shows that both small-cap stocks and value stocks tend to earn higher returns than large-cap stocks. We continue to believe that portfolio tilts toward small-cap and value stocks are the most reliable way to enhance expected return. Such tilts, however, can go through periods of underperformance, in the same way that stocks can underperform bonds for extended periods of time. This underperformance of small-cap and value stocks is what investors experienced over 2014 and 2015.
Over the very long term, U.S. and international stocks have tended to have similar returns, although performance can diverge significantly over other periods of time. Figure 2 on the following page makes this point by looking at the returns of U.S. and international stocks over each decade starting in the 1970s as well as the period of 2010–2014.
Figure 2: U.S. vs. International Stock Annual Compound Returns (1970–2014)
In each decade, U.S. stocks have significantly outperformed international stocks or vice versa. Thinking more deeply about the data, many investors were clamoring for international stocks in the ’90s after their superior performance of the ’80s, only to see U.S. stocks substantially outperform in the ’90s. We now see some investors tempted to increase their allocation to U.S. stocks after a period of strong performance. But will the outcome be better than moving more heavily into international stocks after the ’80s? We don’t think so and would instead argue that the best approach is to maintain a long-term, substantial allocation to both U.S. and international stocks since no one knows which will outperform the other over the long term. Concentrating in only one country is not a prudent approach to portfolio diversification.
PERSPECTIVE ON MARKET TIMING
Market-timing decisions can take a number of forms, whether across stocks and bonds or across other asset classes like small-cap stocks versus large-cap stocks. The temptation is to believe that seemingly long periods of past performance tell us something about future performance. If U.S. has outperformed international for the past 10 years, shouldn’t we increase the allocation to U.S.? If value stocks have underperformed growth stocks for five years, shouldn’t we reduce the allocation to value? These are temptations investors face when looking over past periods, and there will no doubt be different temptations in future periods. What we know, however, is that it is very difficult for either individual investors or professional investors to successfully execute marketing-timing strategies precisely because past returns data tells us very little about the future.
“Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”
“Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”
– Warren Buffett
To further Buffett’s points, we want to illustrate the historical ineffectiveness of one particular type of market-timing strategy based upon past performance. A common strategy is to look back over three- or five-year performance periods and re-allocate assets into strategies that have performed well over those windows of time. This behavior is referred to as “returns chasing” and, unfortunately, is still a common method investors use to make portfolio decisions.
Using returns data covering the period of 1928–2014, we can illustrate the performance of this type of strategy implemented across the asset classes of U.S. large-cap growth, U.S. large-cap value, U.S. small-cap growth and U.S. small-cap value stocks. Our hypothetical market timer’s strategy is to look back over the past three years of returns across the four asset classes and re-allocate all assets to the one asset class with the highest return over that period of time. Our market timer then repeats this process every three years. We then compare the returns of this strategy to the returns of simply splitting the allocation equally across the four asset classes. Figure 3 reports the results.
Figure 3: Market Timing v. Buy, Hold and Rebalance (1931–2014)
We see that the timing strategy earned markedly lower returns than the more straightforward approach of allocating assets equally across the four asset classes. Further, this simple example ignores the impact of taxes, which would further reduce the returns of the timing strategy relative to the equal-weight strategy.
SUMMARY
Although many investors have gone through a recent period of underperformance relative to market benchmarks like the S&P 500, we believe that broad diversification remains a crucial component of a well-thought-out investment plan. The long-run evidence shows that such periods will indeed happen, but investors are best served to avoid the urge to engage in returns-chasing behavior. Strategies that chase high recent performance tend to reduce — not increase — long-term performance.
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