Willow Creek Commentary: Fall-2018

DIVERSIFICATION – WHERE’S THE BENEFIT

As the financial media shouts, “Stocks soar to new highs,” and promotes the strong performance of the S&P 500 or the Dow Jones Index, investors may be asking “Where are my investment returns?”

So far, 2018 has proven to be a year when all asset classes other than US Large Companies, or “TV Stocks,” have been a drag on returns for the diversified investment portfolio. And once again, investors start to question the benefits of diversification in bonds and international stocks or the long-term return premiums in value and small companies.

BONDS – Rising Interest Rates?

It seems like a foregone conclusion that interest rates are rising, so why suffer a principle loss by investing in bonds?

First, there’s no guarantee rates will continue to rise in the short-term – unexpected policy or economic events could result in downward pressure on rates. Rates do not have to rise just because they are low and may not keep rising just because they have recently.

If interest rates do continue to rise, investors can mitigate some of that risk by avoiding long-term bonds. Investors in short and intermediate term bonds can more frequently reinvest new principle at higher interest rates. After more than a decade of historically low-interest rates, bond investors should welcome higher interest rates with expectations of higher long-term returns.

A successful and efficient investment portfolio is not only about returns – but it is also about diversification and downside protection. The primary source of risk (and returns) in your portfolio are stocks, the primary role of the bonds is that of safety and security in times of financial stress. Your total return experience will be less volatile if a disciplined bond allocation is maintained over time.

INTERNATIONAL STOCKS – Superb U.S. Growth?

As U.S. economic growth outpaces that of most other foreign developed nations and trade fears suppress emerging markets, why not concentrate our investment in U.S. stocks for now? The unexpected jump in last quarter’s economic growth and corresponding stock returns is yesterday’s news!

What happens to U.S. earnings growth now that tax cuts have been priced in?   How will tariffs and trade sanctions impact U.S. technology companies importing components from China?   Will Emerging Markets rally if trade tensions calm down?  What will happen tomorrow is unknowable today, and this uncertainty is a component of future investment returns.

Constantly reacting to yesterday’s news has proven to be an expensive and unreliable method for managing an investment portfolio.  By pursuing a globally diversified approach to investing, one does not have to attempt to pick winners to achieve a rewarding investment experience.  It is helpful to remember that history has not shown any one market around the world to be a consistent outperformer.

We only need to look back as far as the last decade (2000 – 2010) when U.S. Large Stocks generated a 10-year annualized return of 0%.  By expanding the investment opportunity set beyond the U.S. stock market investors can help increase the reliability of outcomes.

RETURN PREMIUMS – Expectations and Perception

1. Stocks have higher expected returns than safer investments like Treasury bills. It is widely known that stocks are riskier; investors are motivated to bear that risk with higher expected returns. The higher expected return for stocks is known as the equity premium and, historically, it has been about 8% annually in the US.

2. All stocks don’t have the same expected return.  A stock’s price has many inputs. Expectations about future profits, different types of risk, and investor preferences are just a few examples. All available information should already be reflected in the price, which tells you something about expected returns. Whether you are a consumer or an investor, you want to pay less and receive more.

Therefore, expected returns are a function of the price you pay and cash flows you expect to receive. Small value companies which are more profitable, have higher expected returns than large growth companies that are less profitable.  These patterns are referred to as size, value, and profitability premiums. They have historically ranged from slightly more than 3.5% to just under 5% in the US as shown below.

3. Expected premiums are positive but not guaranteed. 
Although expected premiums are always positive, realized premiums may be positive in some years and negative in others. You may even experience a negative premium for several years in a row. The probability of earning a positive premium increases with your time horizon, but it is not a sure thing since underperformance is possible over any time frame.

 

Perception

Consider an event, such as realizing a negative “premium” over 10 years, a time frame that most investors consider long-term.  Lengthy periods of underperformance are disappointing, as investors obviously prefer higher returns. Nonetheless, disappointment should not turn into anger or regret if you know in advance that periods like these will occur and you recognize you can’t predict them.

Ancient wisdom teaches acceptance, as resistance often fuels anxiety. Instead of resisting periods of underperformance, which might cause you to abandon a well-designed investment plan, try to lean into the outcome. Embrace it by considering that if positive premiums were absolutely certain, even over periods of 10 years or longer, you should not expect those premiums to materialize going forward. Why is this? Because in a well-functioning capital market, competition would drive down expected returns to the levels of other low-risk investments, such as short-term Treasury bills. Risk and return are related.

The good news is there are sensible ways to increase expected returns. The bad news is there will be periods of underperformance along the way.

Your happiness as an investor depends on how your perception of events stacks up against your expectations. Proper expectations alongside the appropriate perception can help you stay the course and may improve your wealth and well-being.