THE WILLOW CREEK PORTFOLIO: The US Market and Beyond
As US-based investors, it is hard not to focus on the US stock market and think that it should be the sum of your returns: your portfolio should be up when the S&P 500 index is up and down when it is down. Sometimes that is the case but many other times it is not – for better or worse.
UNDERSTANDING DIVERSIFICATION
Indeed, by design our portfolios are comprised of many different types of investment classes and not just the S&P 500 (which is an index made up of large US-based companies). Instead our portfolios are made up of a blend of stocks and bonds, large companies and small companies, US companies and international companies plus short-term and intermediate-term bonds. There are many different components each with their own return characteristic - some are riskier than others and have better long-term growth possibilities, others are less risky and provide more stable earnings. When blended together they create a diversified portfolio. The thing about a diversified portfolio is that it will, by nature, never be the best performer or the worst; instead it will be the weighted average of all those holdings. By not being the best or the worst, it will avoid the hard swings we have seen just play out in the US markets over the past few months. Around the end of the 3rd quarter 2018, the US stock market was the best performing of the major global markets with the S&P 500 index up 10.56%. But, by comparison, international and emerging markets were flat to negative as were fixed income investments. Therefore, if you had a fully diversified portfolio you would have seen only modest growth for the period - not the out performance you had hoped for or maybe expected if you were listening to the media on the “market” (i.e., the S&P 500). Unfortunately, the tide turned on the US markets and they ended up under-performing other global markets by the close of the year. So, in the 4th quarter, the broad US market lost more (-13.5%) than international (-11.5%) and emerging market (-7.5%) stocks and fixed income (+1.6%).
VOLATILITY IS NORMAL
Just to clarify, this kind of downdraft is normal in stock markets. For example, we have seen an average decline of nearly -14% in the US markets at some point every year since 1980. But overall the annual compound return has been almost +9%. To get those types of positive returns we often have to endure the down times. This increased volatility underscores the importance of following an investment approach based on diversification and discipline rather than prediction and timing. For investors to successfully predict markets, they must forecast future events more accurately than all other market participants and predict how other market participants will react to their forecasted events. There is no evidence suggesting that neither of these objectives can be accomplished on a consistent basis. So, instead of attempting to outguess the market, investors should recognize that relevant information is quickly incorporated and is reflected in expected returns.
THE CASE FOR GLOBAL DIVERSIFICATION
When considering investing outside the US, investors should remember 1. that non-US stocks help provide valuable diversification and 2. recent performance has not been a reliable indicator of future returns. If we look at the past 20 years going back to 1999, US equity markets have only outperformed in 10 of those years. The S&P 500’s “lost decade,” for example, recorded its worst ever 10-year cumulative total return of −9.1%, while international indices such as the MSCI World ex USA Index returned +17.5%, and the MSCI Emerging Markets Index returned +154.3%. In periods such as this, investors were rewarded for holding a globally diversified portfolio.
LOOKING FORWARD: PREPARING FOR 2019
While we cannot control the markets, we can control how we invest. As we commonly say, “control what you can control.” To that end, what are the things we can do to help us control our financial future? What are the best practices we can follow that will ensure we can get through volatile markets over the coming year?
Do nothing and let us do the work.
When the markets are volatile there is a lot going on behind the scenes here at Willow Creek Wealth that you might not be aware of. We are looking at rebalancing your portfolio (buy low/sell high), tax loss harvesting and proactively monitoring your investments. So, if you have a diversified portfolio in place, guided by a relevant investment plan, your best move in difficult markets is to let your advisor and that plan be your guide. It can be tough to endure these periodic downswings but reacting to them will more often hurt you in the long run. After all, over the past 38 years, the market’s average annual return was almost +9% and was up 75% of the time.
Prepare for the unknown with a rainy-day fund.
Time will tell whether 2019 markets are friendly, foul, or (if it’s a typical year) an unsettling mix of both. Having enough liquid reserves to tide you through any rough patches is a best practice no matter what lies ahead. Knowing your near-term spending needs are covered allows you to leave the rest of your portfolio fully invested as planned, even if/when the markets take a turn for the worse.
Do some financial planning.
That said, a “do nothing” approach to turbulent markets hinges on having that relevant plan in place, guiding your portfolio. A fresh new year can be a great time to tend to your investment plan – or create one, if you’ve not yet done so. Have any of your personal goals changed, or will they soon? It’s time well-spent to periodically ensure your plan remains relevant to you and your personal circumstances.
Focus on the financial matters that you can control.
When was the last time you reviewed your insurance policies? Is your estate plan up to date? Is your debt load appropriate? Do you feel like you are under earning in your career? Or over spending and not saving enough for retirement? Have you done an audit of your cyber security risks such as regular password changes, credit freeze, etc.? These are all items that your advisor can help with and are likely to contribute more to your financial success than something you cannot control – the stock market’s daily gyrations.