Monday, December 1, 2014

Why We Don't Chase Returns

This year, 2014, has been interesting so far. One major asset class, large US equities, is doing very well, compared to most other asset classes.  That’s great if you own large US equities (and we certainly do!). Having other asset classes, like small cap stocks and emerging markets, can make it trying, since all we ever hear about is the S&P 500 or the Dow. Ever hear the commentator on the news say, “today the MSCI Emerging Market Equity Index was up 1.4% on lower oil prices”?  A question we sometimes get is: ‘Why aren’t we doing as well as the Dow/S&P/NASDAQ?’  Well, two observations:  While we like large US equities, they are not the only asset class.  Small US equities historically have outperformed large US equities. Can you name a large stock that wasn’t once small?  Additionally, international equities provide valuable diversification and real estate is also a good asset class.  Although we can talk about it, it may be just as easy to show, so here’s a chart from JP Morgan:

If you are correctly interpreting the chart, it shows the nine major assets classes (we use them all) and an asset allocation somewhat similar to ours.  So in 2006, REITS, which we have, did stellar (35.1%).  In 2007, they were the worst (-15.7%).  In 2008, cash was second best, and in 2009, cash was worst.  Similarly, in 2008, emerging markets did terribly at -53.2%, followed by being the best performer in 2009 at +79%. The last column shows the annual return of each class.  It’s interesting to note that over 10 years, the asset allocation portfolio did just slightly less than the S&P 500, with considerably less risk (it’s about 35% fixed).

The point of this chart is straightforward:  no single asset class ever dominates the chart, and frequently the top performer slides to the lowest performer.  If you look closely, the light blue ‘allocation’ mix was in the middle-upper portion of the table the entire ten year period, and this holds for longer periods as well. That’s the strategy of asset allocation:  don’t try to hit the ball out of the park, win the game.  And the sweetener?  Rebalance it so that you take profits off the highest asset classes and buy more of the lowest performing asset classes.

One last note:  Cash, as we all know, is not really an investment, but a form of liquidity and a protector.  Note the relative position of cash in the long run.