October: This is one of the peculiarly dangerous months to speculate in stocks.
The others are July, January, September, April, November, May, March, June, December, August and February.”
– Mark Twain
2014 will not stand out as the poster child for global diversification. As interest rates stayed low, longer term bonds continued to perform well, Real Estate benefitted enormously (more in the US than outside of it) and the returns for US Stocks surpassed the non US market averages of the developed and developing world. The charts following help to walk you through the recent leaders and laggards of the global financial markets.
In a nod to Mark Twain, we’ll go out on a limb and state that January – like October – is a particularly bad month to put much faith in predictions about the stock market. As you know we don’t make predictions or listen to those that do. We capture market returns from a globally diversified portfolio and periodically rebalance the portfolios, enabling us to sell high and buy low.
We have received a few comments and questions from clients who have noticed their overall portfolios have not kept up with the soaring US stock market of 2014, much less some of the specialized areas such as biotech and technology in general (another big year for Apple – more on that later). Since our approach to investing considers risk first and return second, we thought this might be a good time to highlighting what diversification does for you.
Diversification Benefit #1 – reducing losses makes it easier to make money over time. Basic arithmetic shows us that a 50% decline requires a 100% gain to break even, just getting back to where we started. Smaller declines require smaller gains to recover. Consider two portfolios, both of which average zero return after two years. One, a tortoise, loses 10% then gains 10% the following year. The other, a hare, drops 50% in year one then sprints back with a 50% gain in year two. Where do they end up after two years?
Diversification Benefit #2 – Protection from the randomness of market performance. You may recognize the table below from our recent newsletter, in which we posed the question, “Is diversification a drag?” (updated to include 2014). Note that over the last decade only in the last two years has the US outperformed the other markets. It is easy to fall victim to “recency bias” which is the tendency to mistakenly think that which has happened most recently is more likely to happen again. When one invests affects one’s opinion of what they should invest in. Up through 2007, for example, Emerging Markets vastly outperformed the US Stock Market due to a winning streak from 2003-2007. The last two years have brought US returns up and Emerging markets down. It’s easy to see why people who had been invested in Emerging Markets beginning in 2003 would have a different view of them than those who had only been invested in them since 2013. Recency bias is one reason we often are warned that past performance is not an indicator of future results.
Diversification Benefit #3 – Lower Volatility. Boom and Bust Cycles are an integral part of the fabric of entrepreneurship and capitalism. Volatility comes with the territory. Over the decades we have seen dramatic rises and falls in any number of industries, be they railroads, radio, technology, biotech, oil, gold, real estate – this list goes on. In each case, concentrated bets in an industry or even a specific company have created and erased fortunes at astonishing speeds. Not too long ago, predictions of “Peak Oil[i]” leading to scarcity and economy choking high oil prices were common. Last year, due to a number of factors including new technologies and geopolitics, the price of crude oil fell 50% as supplies surged. Those betting on the rising price of that commodity suffered major losses on what had seemed to them to be a solid bet that a wealthier world population would consume more oil and drive the prices up. The charts below are created using the statistics of historic risk, return and correlation over time. They can’t predict when we will experience a loss or a gain, but they can tell us the range of gains and losses to expect with about 95% confidence over a six month period of time. The chart on the left is for an Index fund that tracks the price of oil, Apple stock is in the middle and a fund investing in nearly 12,000 stocks around the globe is on the right. The diversified global stock fund has an expected decline 40% to 50% less than the oil sector or Apple stock bets with a relatively attractive expected upside. This is why we diversify.
We would love to hear from you to review the risk, return and diversification of your investments or just to touch base on other topics of interest.
[1] Peak oil, an event based on M. King Hubbert‘s theory, is the point in time when the maximum rate of extraction of petroleum is reached, after which the rate of production is expected to enter terminal decline.
[1] Source: Riskalyze analysis of Oil – IPath S&P GSCI Crude Oil Total Return Index ETN, Apple Stock (AAPL) and DFA Global Equity Mutual Fund (DGEIX) based on volatility and correlation. Expected returns are not predictions or guarantees of future results.
