How diversification allows you to sleep better at night

by James Parkyn

It seemed as if nothing could stand in the way of U.S. tech stocks. Since the spring, giants like Apple, Amazon, Facebook and Tesla climbed ever higher despite a worsening pandemic in many states and a deep recession gripping the global economy.

That changed in early September when without warning U.S. tech heavyweights hit a wall. A sharp tech sell-off dragged the wider U.S. market down with the S&P 500 falling 7% over just three trading days.

No one can say whether U.S. stocks will continue to fall in the coming weeks or recover to hit new heights. But looking back at the relative performance of world stock markets, you might be tempted to bet heavily on a U.S. market rebound.

After all, U.S. stocks have been on a tear over the last decade. The S&P 500 Index had an annualized compound return of 13.6% from 2010 to 2019. That compared to 5.3% for developed markets outside the U.S (MSCI World ex USA Index), and just 3.7% for the MSCI Emerging Markets Index.

However, you only have to look a bit further back in history to understand why it’s so important to not become transfixed by recent returns in any one market.

The last time the U.S. market surged to extraordinary heights was during the dot.com years of the late 1990s. When the bubble burst, there followed a period from 2000-2009 that’s come to be known as “the lost decade” for the U.S. stocks. In those years, the S&P 500 Index recorded one of its worst 10-year performances with an annualized compound return of minus 0.95%, according to this report from Dimensional.

By contrast, emerging markets during those years produced an annual compound return of 9.8%. So a portfolio diversification strategy that included exposure to emerging markets would have buffered your poor U.S. returns.

A closer look at historical performance of emerging markets sheds even more light on the potential benefits of diversifying your portfolio outside the U.S. and Canada.

Another report from Dimensional notes that a consistent allocation to emerging markets from 1988 to 2019 generated an annualized return of 10.7%. That beat the 5.9% from developed markets outside the U.S. and was similar to the 10.8% generated by S&P 500, including the strong returns of the last decade.

Now you would have had to put up with a lot of volatility in emerging markets during that period, much more than in developed markets, underlining the need for patience, discipline and appropriate asset allocation, the Dimensional report cautions.

However, the report also notes that emerging markets are not only a growing segment of global markets (12.5% of global capitalization at the end of 2019), but also generally “have become more open to foreign investors with fewer constraints on capital mobility.”

The composition of these markets has also evolved. While you might think of emerging markets as primarily resource based, you would be mistaken in the case of Asian economies such as China, Taiwan and South Korea where the technology sector is flourishing. Indeed, the leading sector weighting in the MSCI Emerging Market Index is information technology at 18.4%.

The benefits of geographic diversification are clear. Investing in global markets lowers your portfolio risk by exposing you to a wider set of economic and market forces than those provided by just the U.S. or Canadian markets.

By ensuring your portfolio has the right mix of assets to provide maximum diversification, you are giving yourself the best chance of reaping the returns that global markets have to offer while controlling the amount of risk you’re taking.

In part 2 of this series, I will look at the other forms of diversification and the dangers of “di-worse-ification.”

Look beyond the headlines: Patience is the key to building wealth

by James Parkyn

In the spring of 2008, the New York Times published an article with the headline: An Oracle of Oil Predicts $200-a-Barrel Crude.

The oracle in question was Goldman Sachs equity analyst Arjun Murti who was predicting a “super spike” in the price of oil, continuing a run that had brought it to $130 a barrel at the time the article ran in May 2008. (All figures in U.S. dollars.)

“The grim calculus of Mr. Murti’s prediction…is enough to give anyone pause: In an America of $200 oil, gasoline could cost more than $6 a gallon,” the article says.

As the piece noted, Murti was far from alone in forecasting a further surge in oil prices. In Canada, former CIBC World Markets chief economist Jeff Rubin also called for $200 a barrel oil and even wrote a book describing all the implications for the economy.

Sadly for these analysts, the stage had already been set for the collapse of oil prices. The 2008-09 financial crisis and accompanying recession sent prices to below $40 a barrel. But it wasn’t long before prices were climbing again and the oil bulls were back at it, only to be disappointed when the fracking revolution helped flood the world with crude.

It’s been a quite a rollercoaster. Now, think what would have happened to your investment portfolio had you actually taken these headlines seriously and loaded up on the stocks of energy producers and other companies that benefit from high oil prices.

Every day you can find predictions from stock analysts, professional investors and economists about what’s going to happen in the markets.

These forecasts are often persuasively argued, pointing to “fundamentals,” market history and various data points. And they are often wrong.

In fact, the evidence is that the experts are no better at seeing into the future than you and me. Their predictions have been proven wholly unreliable as demonstrated in another Times article. It reports on research into the forecasts made by Wall Street strategists between 2000 and the end of 2019.

“The gap between the median forecast and the market return was 4.31 percentage points, an error of almost 45 percent,” the article says. “The median forecast was that stocks would rise every year for the last 20 years, but they fell in six years. The consensus was wrong about the basic direction of the market 30 percent of the time.”

Actually, market predictions are worse than useless because they generate media commentary that can throw your investment plan off track.

To better understand the danger to your financial health, you only have to think back to the dire headlines at the time the market was falling in February and March in response to the pandemic crisis. For example, a headline in the Globe and Mail on March 12 warned A significant bear market is just starting.

We know in hindsight the market would bottom just 11 days later. On that day, a powerful rally began that saw stocks rise 38% in Canada and 40% in the U.S to the end of June. By the end of August, client portfolios we manage had returned to close to their opening value at the beginning of the year. If the negative headlines had scared you out of the market in March, you would have missed out on that rally.

Of course, we might be headed for another market downturn if there’s a serious second wave of the pandemic or some other negative event in the weeks ahead. And that’s the point—we just don’t know what’s going to happen and neither does anyone else.

However, we do know that $1,000 invested in world equity markets in 1985 would have turned into $28,000 by the end of 2019. That’s why it’s so important to tune out the day-to-day noise and focus on long-term returns.

It may not be exciting, but the only investing news that matters is that patiently holding a broadly diversified portfolio that reflects your tolerance for risk through good times and bad is the best way to build wealth.

Embrace market pricing: The foundation of sound investing

by James Parkyn

When the stock market was falling in February and March, it would have been natural to worry about how bad it was going to get and whether you should cut your losses. It’s at times like those that emotions can cloud your judgment and lead to rash decisions.

But you only have to look at the rapid market recovery in the months following the market decline to understand just how dangerous that kind of short-term thinking can be to your long-term financial health.

If you had bailed out when markets hit bottom on March 23 (after declining 37% in Canada and 35% in the U.S.), you would have missed out on the powerful rally that followed. You would have been left to regret your decision as the market climbed day after day. By the end of June, the market had rallied back 38% in Canada and 40% in the U.S.

To avoid those kinds of mistakes and be successful at investing, you have to give up on the seductive idea that you can outsmart the market. Instead, you have to embrace market pricing where you strive to efficiently capture returns over the long term.

It’s often challenging for smart, successful people to accept that they should aim to earn market returns, especially when the financial industry and the media are constantly telling them they can beat the market.

But consider the difficulties of choosing individual securities, or actively managed funds, that will outperform an index such as the S&P/TSX Composite or the S&P 500.

You or your fund manager will be competing against millions of sophisticated investors around the world who buy and sell securities every day. Collectively, they instantaneously process all available information and expectations about securities. Their trading decisions set market prices that reflect all that information. Of course, new information and events will cause prices to change, but these are inherently unknowable until they occur.

This is the essence of the efficient market theory developed by University of Chicago professor Eugene Fama in the 1960s. In the years since Fama, who won the Nobel Prize for economics in 2013, asserted his theory, other academic researchers have described circumstances where securities may be mispriced. Notably, behavioural economists attribute mispricing to various psychological errors and cognitive biases, such as overconfidence and loss aversion.

However, while securities may be mispriced at times, the challenge is to consistently recognize when this is the case. The evidence is that even the most sophisticated investors with the best resources are unable to do this regularly.

Indeed, actively managed investment funds consistently underperform low-cost passive index funds by a wide margin. For example, Standard & Poors reports that 89% of U.S. domestic equity funds lagged their benchmark over 10 years to the end of 2019.

Regardless of what you might read or see in the media, the reality is that no one can predict what’s going to happen in the future and what impact it will have on the markets. By embracing market pricing, you get off the treadmill of trying to forecast the future with all the emotional turmoil and potential for bad decisions that come with it.

Instead, you accept that volatility like we experienced in February and March is a normal if unpleasant part of investing. You prepare for it by holding a portfolio of passive investments that is broadly diversified within and across asset classes and geographies.

Truly smart investing isn’t about outthinking the markets. It’s about patiently sticking to an investment plan that allows you to capture market returns over the long term.