10/05/2018 Weekly Update: It Seems Easy but it Ain't
by Zach Marsh on Oct 12, 2018
S&P 500 -0.32%
10 Year Treasury +0.14%
Weekly Update: It Seems so Easy But it Ain’t
As the stock market keeps trudging higher, returns look like they should be easy to achieve. Two weeks ago we highlighted the narrow nature of the 2018 version of the bull market. The S&P 500 is up 9%, the Russell 2000 small cap index is up 7.6%, but that is where it ends. Vanguard’s European index fund, VGK, is down roughly 6% year to date. Vanguard’s emerging market ETF, VWO, is down over 13% on the year.
As American investors we tend to focus on the home team. But one tenant of prudent investing is to reduce as many investment risks as possible. Geographic stock market risk is one of those areas which can be diversified. Sometimes it is beneficial, but sometimes it isn’t. From 2000-2007 a portfolio consisting of 70% developed international stocks and 30% emerging markets stocks far outperformed the S&P 500 index. Over that timeframe, the international portfolio averaged 8.33% annual return vs a 1.56% annual return for the US benchmark. Conversely, from 2008-2018 the numbers are nearly exactly opposite: 8.77% annual return for the S&P 500, and 1.73% for international.
Another area of risk protection in portfolio management is diversifying between asset classes. While stocks grab all the headlines on the evening news, placing 100% of your investments in equities can be fraught with danger. Stock markets can be fickle, at times the movements can appear arbitrary and capricious. They are subject to violent moves and while be a great creator of wealth, they can also be a great destroyer of wealth. Since 1987, the S&P 500 has seen 3 drawdowns from peaks to troughs of 30% or more. Two of the drawdown periods have been in excess of 42%. Combining all three drawdown periods, the drawdown period lasted 44 months, and the time spent recouping the losses took 110 months. That means that in these three instances, the S&P 500 spent 13 years underwater, or roughly 40% of the time.
Good markets, like the one we are currently in seem enticing, but the music eventually comes to a stop and a chair is needed. This is why we diversify between assets. Bonds and hard assets, like gold and other commodities, can provide a counterbalance to equity risk. Year to date, blend of long-term and intermediate term government bonds is down over 5%. But, for balancing the stock market, few things can protect like US government bonds. This same blend of US bonds produced returns of 17% in 2008, and a 3-year total return of over 42% between 2000-2002. A simple portfolio of 50% government bonds and 50% S&P 500 would’ve lost only 2.9% between 2000-2002 and 10% in 2008. Compared to the S&P 500’s losses of 37.7% and 37% respectively.
Diversifying, or hedging one’s risk never feels good when the one thing that gets our attention is the one thing that is appreciating—sometimes it can even create short term losses. However, drawdowns and time spent underwater are substantially improved, historically, by diversification. Since 1998, a diversified portfolio spent nearly 67 fewer months underwater than an all large cap US stock investment. Losses are part of investing.* When diversifying the goal is to make the losses shallower and less painful. The unfortunate side of diversification is that sometimes the drawdown periods don’t coincide which can cause near term uncomfortableness.
Thanks for reading,
Zach and Dave
Portfolio 1= S&P 500 Portfolio 2= Diversified Portfolio
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