Diversification has always been a cornerstone of our investment philosophy. The idea of not putting all our proverbial eggs in one basket has been supported by practitioner and academic research for some time, and, considering that we are dealing with your life savings, it’s an investment approach that just makes sense.
Yet, it’s also an investment approach that has been challenging for U.S. investors to stick with over the past several years. Looking back, the U.S. stock market has been one of the best, if not the best, in the world for a little over a decade. Our efforts to diversify into non-U.S. stocks and away from the large growth stocks that dominate so many popular indexes likely have led to relative underperformance versus the S&P 500 or Nasdaq 100.
Given these challenges, maybe you are wondering if our investment strategy still makes sense. The questions we hear generally touch on two ideas. First, we’re asked whether this time could be different or if something has changed that would make all the research behind our approach irrelevant. Second, we’re asked whether we should just invest in the S&P 500 or for a more market-like portfolio. Let’s explore these questions.
Is it different this time?
When investment prices seem to defy logic, either up or down, we gravitate to the idea that something has changed. We create a storyline that fits the environment and it may work for a time. Yet, that time is often short-lived.
Naturally, the global headlines and economic conditions that cause investments to perform the way they do will change, and that surely makes every time feel different. However, from an investment perspective, we’ve likely seen this before.
Small value stocks significantly underperformed large growth stocks for long stretches in the 1930s and in the late 1990s. While we of course can’t guarantee it will happen again, small value stocks had strong returns following those periods of underperformance.
Historically, U.S. stocks were rarely the best performing country in a given year, let alone for an entire decade. In fact, we only have to revisit the 2000s, the “lost decade” in which the S&P 500 lost money over a 10-year period, to be reminded that investing in developed and emerging non-U.S. stocks can help smooth out our investment results.
Further, we don’t see a change to the fundamental ideas supporting our investment approach that would suggest it is time for a change. The strategies we pursue are based on factors of return that are persistent, pervasive, robust, intuitive and investable. They are not guaranteed. Yet, nothing produced in practitioner or academic literature disproves the foundation of our investment strategy.
We continue to believe that we should expect small value stocks (i.e., small, inexpensive companies) to beat large growth stocks (i.e., large, expensive companies) every day, week, month and year. And, just as important, we know expected returns can and will be different than realized returns. But this doesn’t mean we shouldn’t pursue them. It just means we have to be prepared for periods, like the one we are in right now, when we don’t receive these return advantages.
Should we invest more like “the market”?
As we mentioned earlier, the U.S. stock market has been one of the best in the world. After a decade of dominance, it makes sense that some investors would like to have more of their portfolio look like the U.S. stock market. Let’s entertain this idea and see what would happen if we opted to invest this way.
The U.S. stock market has significant exposure to a handful of large companies mainly considered growth companies. The five largest companies in the S&P 500, which tracks large U.S. stocks, represent almost 22% of the index’s total market capitalization. The five largest companies in the Russell 3000, which tracks both large and small stocks, represent over 18% of the index’s total market capitalization.
If we changed the way we invest in stocks to look more like either of these popular market indexes, it would mean that we would sell some of our smallest, cheapest companies and buy some of the largest, most expensive companies.
Looking back, we might say that was a good decision because those top five stocks posted some of the best returns over the recent past. But looking ahead, it means that our portfolio returns would be very dependent on how a small number of companies perform. Stated another way, investing more like the market would mean un-diversifying your life savings. Relying on just a few stocks to help achieve your goals doesn’t seem like an investment strategy, it seems like speculation.
We understand that geopolitical and economic conditions make everything seem different, and there is always the temptation to chase what has done well recently. The reality is that we can’t control the future, but we can control how we allocate our portfolios. And the evidence continues to tell us to diversify our stock holdings and emphasize exposure to small and inexpensive stocks. Now is not the time to change our investment strategy.
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