A fundamental principle of financial economics is the idea that risk and return are inextricably linked. However, when it comes to investing, not all risk is equal. In an interview several years ago, Nobel laureate William Sharpe said, “There is a reward and higher expected return for bearing risk, but not just any risk. It’s the risk of doing badly in bad times. It’s that central societal risk that, in an efficient capital market, is going to be rewarded with higher expected returns.”
As investors, we should not expect to be rewarded for taking on company-specific or industry-specific risk that can easily be diversified away. By diversifying broadly across U.S. and international equity markets, you are left with central systematic risk. Stock markets are priced to reward this risk with an expected rate of return above and beyond U.S. treasury bonds, referred to as the equity risk premium.
Although many investors look to the S&P 500 index as a barometer of market performance, the U.S. stock market is much broader than the S&P 500, which is limited to large cap U.S. stocks. While the S&P 500 has performed well recently, there have been periods when it has not done so well. For example, during the so-called “lost decade” from 2000 to 2009, the S&P 500 returned -0.9% per year, or -3.4% after inflation. During this same period, a broadly diversified portfolio of U.S. and international stocks returned an average of +5.4% per year. This serves to highlight how diversification may allow investors to capture returns wherever they occur.
There are also periods when the S&P 500 does well relative to other asset classes. In the graph below, the 10-year rolling returns of the S&P 500 are compared to the Dimensional Equity Balanced Strategy Index, a broadly diversified portfolio consisting of 70% U.S. stocks and 30% international stocks:
As shown in the above graph, the S&P 500 has done well recently relative to the broader Balanced Equity Strategy, but for a majority of periods it has lagged the Balanced Equity Strategy.
Over the long run, the more broadly diversified strategy has provided better returns. With the power of compounding, even small differences in annual returns can have large effects over time. As shown below, $1 invested in 1970 in U.S. Treasury Bills, the S&P 500, and a broadly diversified global equity strategy would have grown to $9.29, $122.32, and $477.62, respectively, by 2017:
At Shearwater, we construct well-balanced portfolios that are broadly diversified across a wide range of U.S. and international equities. We emphasize small cap and value stocks, which have historically outperformed the overall market, but we do not exclude other asset classes such as large cap and growth stocks. This helps to smooth out the equity curve over time. For most clients, we also use fixed income securities to temper overall portfolio volatility.
While these measures help to dampen the volatility of investment returns, there is no way to eliminate investment risk. As an equity investor, you will inevitably go through periods when your portfolio declines in value. Successful investing requires some faith that capital markets will reward patient investors, as they always have. It takes discipline and a long-term outlook to stick with a sound investment plan through good markets and bad.
As always, please feel free to contact me if you have any questions, comments, or concerns.
Jeffrey J. Brown, MD CFA Principal, Shearwater Capital
Source: Matrix Book 2018: Historical Returns Data. Dimensional Fund Advisors.