Statement

Pay attention to asset classes, not returns

Link Joshua VanDykeLeave a comment

When people think about deciding between investment advisors, or mutual funds, or even stocks, the temptation is to look at past performance. That’s the default. And it seems basic, you’re looking for returns, what else would you look at? What else could you even look at?

The problem is the past performance we see is short term. You’ll see three to five year histories on your account statements, Morningstar defaults at a ten year history (if the fund has been around that long), and the news rarely talks about anything further back than the last year. Those are relatively short periods of time, especially when we’re talking about market returns. Instead of comparing past performance in advisors and mutual funds over the past ten years, we should be looking at long-term historical returns of asset classes.

An asset class is a group of similar securities that tend to move together. The main general asset classes are equities (stocks), fixed income (bonds), and cash. Each of these, but especially the equities group, can be broken down further. In equities, we see large vs small, value vs growth, U.S. vs international. For an example, a very popular asset class is U.S. Large Growth, which is basically the S&P 500. We have returns data on these asset classes all the way back to the early 20th century. That information can tell us much more than the past ten years. We can see which asset classes tend to outperform others, we can see how the different asset classes correlate to each other, and we can know what returns and risk a fund or portfolio can expect over long periods of time. A ten-year history of returns is almost irrelevant. Over ten years any asset class could outperform any other, but we don’t know when or which. So to look backward at the performance of a fund is not only unhelpful, it’s more often hurtful. A good ten-year history on a fund, or even an asset class, deceives us into thinking the performance will continue in the future. The short-term history the only information we know to use, and besides that, it seems to make sense. But that’s the opposite of a good investing strategy. Instead, let’s analyze the asset class data going back as far as it goes, understand where returns come from, and diversify our portfolio’s in a way that’s consistent with the data. Then we let the market perform and deliver results. Our balanced diversified portfolio won’t always be the big winner year by year, but over the long haul, it will outperform anyone trying to predict market movements based on ten-year histories, or any other material information.

What’s going on inside your investment portfolio?

Link Joshua VanDykeLeave a comment

Part of my job is to analyze customer portfolios. The gist is that we dig into the different investments, usually contained within different mutual funds, to figure out what people actually own in their portfolios. For many of us, it’s tough to know what’s going on behind the scenes in our portfolio because the quarterly statements only show pie charts and weird mutual fund names. So, I help to figure out what the actual stock holdings are, then organize the information by asset classes to see how many different asset classes people are invested in and what percentage of their money is allocated to each. Essentially it’s a determination of diversification, which, as we know, is the single most important component of a portfolio (check out Where do returns come from?). It’s a fun exercise, and helpful for clients. The results tend to be a little more sobering.

I estimate that about 95% of portfolios we analyze are not diversified like they should be, and about 75% of portfolios are heavily bent toward one asset class: US Large Growth (S&P 500). Those are estimates, the point is that the large majority of portfolios we see are diversified poorly or hardly at all. There are two problems here: 1) diversification is lacking, 2) the most popular asset class to load up in is US Large Growth.

The first problem has to do with the Modern Portfolio Theory. Lacking diversification means that the portfolio is subject to more risk (volatility) and will expect less return over time than an efficiently diversified portfolio. Many people think that they’re pretty well diversified because of the number of mutual fund names they see on their statement. However, we find that those mutual funds typically have significant overlap with each other. The large majority of portfolios are loaded up in US Large Growth companies because the mutual funds they own are loaded up in US Large Growth companies. Just because there are a bunch of different mutual funds doesn’t mean there are a bunch of different asset classes represented within them. Seldom do we find small companies or value companies within these mutual funds, and we almost never see small value companies. These portfolios also infrequently own anything internationally, which makes up about half of the global stock market (in 2017, the US accounted for 51.3% of the global market, leaving 48.7% often untapped). These asset classes are largely ignored in favor of US Large Growth.

The second problem has to do with the US Large Growth asset class. If US Large Growth was the best performing asset class, a lack of diversification in your portfolio would have at least some defense. The risk would still be higher than it should be, but at least you could expect some decent returns. Unfortunately, that’s not the case. Going back as far as we have air-tight data on the stock market (almost 100 years), US Large Growth has been one of the worst performing asset classes in the world. That’s not to say US Large Growth a total waste, the asset class still provides good returns, and it’s valuable as a piece of a well-diversified account, but the lean towards these companies has a handicapping effect on portfolios. You simply won’t be able to expect the same level of return as you would in an efficiently diversified portfolio. Here’s a snapshot of average asset class returns over the years:

Why do most portfolios lean toward the S&P 500 despite the evidence? It seems that there are a few reasons. 1) The S&P 500 is the popular companies, the ones you’ve heard of, like Apple and Google and Amazon. They’re also all we hear about in the news. The S&P 500, the Dow Jones, and the Nasdaq are all categories of Large US companies. The news cycle is constantly spinning stories about them. They’re familiar companies, and we like to think we know them better. 2) The US Large Growth asset class is cheap to trade in. There is so much trading activity going on with these stocks, they’re always in demand, there’s always a market for them. Since much of the industry is still actively trading in an attempt to beat the market, they have to trade where the trades are cheaper. If they were actively making trades in an account with small value companies, the trading costs alone would submarine any return expectations.

When we see these disappointing results in a client’s portfolio we offer them a few things. 1) For the money they can move, we offer a well-diversified portfolio which will take advantage of returns offered from higher performing asset classes while simultaneously reducing risk. 2) If the money is locked up in a 401k with a current employer, we help them analyze their options within the 401k to get as close to an efficiently diversified portfolio as possible.