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When most individuals look to see how their portfolio has fared over the past one or more years, they compare their performance to the most widely used index of large cap American stocks, the Standard and Poor’s (S&P) 500. This works fine for a purely American equity portfolio. However, many separately managed accounts include exposure to several foreign stocks as well. This makes it necessary to benchmark one’s portfolio using a global index.
Many believe that they don’t need to think globally or own foreign stocks because they get the equivalent through U.S. firms that have heavy sales exposure overseas. However, this does not really have the desired effect since American companies will correlate closely with the S&P 500 and not with the London FTSE, the German DAX or the Japan Nikkei 225. Each country’s stocks will correlate more closely with each other than with those of another country. This is to say that 3M, Johnson & Johnson, and Proctor & Gamble will correlate more closely with each other than they will with Siemens (German), Nestle (Swiss), and Sanofi Pharmaceutical (French).
A good stock market benchmark allows you to control your risk and acts as a guide as you map out your portfolio selections. The benchmark allows you to measure your performance. Without it, you cannot know if you had a good year or a not-so-good year, and by how much. For investors whose goal is “to beat the market,” it is necessary to define which market you are trying to beat. For most, this means the S&P 500 index. For others, it will be the Morgan Stanley Capital International (MSCI) World index. For technology lovers, it will be the Nasdaq 100 index. It is important to remember that “beating the index,” whichever index that is, usually means making riskier bets in the form of a more concentrated portfolio. The cost of being wrong carries the risk of a wide underperformance gap. In statistical parlance, the standard deviation (∑) of your returns will be greater than if you diversify your holdings across all relevant sectors.
Standard deviation leads us to another investing concept that many find hard to believe, which is that all properly constructed indices such as the S&P 500, the Nasdaq 100, the MSCI World, the British FTSE, and the Europe Asia Far East, will provide approximately equivalent returns over long time periods, say twenty plus years. (Notably, this does not include the Dow 30 Industrials due to its unusual construction.) These indices may take widely divergent paths yet invariably they will arrive at the same destination. Narrowly constructed indices such as the Nasdaq 100 will have greater volatility, higher ∑, than more broadly constructed MSCI World, which will provide a smoother ride to its destination. This is important because it debunks a popular myth that higher volatility leads to higher long run returns.
How can this be? Haven’t we all been taught that higher risk leads to higher long-run returns? This concept applies to long-run returns on common stocks versus the returns on bonds and cash. However, history does not bear this out within equity types. If this were true, technology stocks would always outperform consumer staples and utility stocks, long run. Again, statistically speaking, volatility is independent of long run returns. If this were not true, then individual sectors, all more volatile than the complete index, would have higher long run returns than the total index. Of course, this is not possible.
The Long-Term Reality
Equities remained the best performing asset class over the last three decades (through 2014 available data) in both nominal terms and after adjusting for taxes and inflation. They were followed by municipal bonds, long-term government bonds, real estate, and commodities, the worst long-term performing asset class in both nominal and real returns.
|Annual Nominal Return – 1984 - 2014|
|S&P 500 Index||11.34%|
|Russell 2000 Index||10.27%|
|MSCI EAFE Index||9.38%|
|U.S. Treasury Bills||3.68%|
|Residential Real Estate||4.24%|
What accounts for equities’ long-run returns? The growth in the world economy is the paramount long term. Since the Great Recession, monetary ease has helped equities and boosted demand for long-term government bonds, pushing down their yields and total returns. Bonds generate most of their returns from interest income which, for taxable bonds, is taxed in the year it is received. This reduces the amount available to compound over time if it is not held in a tax-sheltered retirement account. Equities by contrast, generate most of their returns from capital appreciation which is not taxed until sold, and even then often at favorable rates.
Despite the long-term outperformance of equities, we advise investors not to put all of their money into that asset class as returns can vary dramatically from year to year. Investment grade bonds provide portfolio stability and dampen portfolio volatility. At Marc J. Lane Investment Management, Inc. we work closely with clients to help determine their optimal asset allocation based on their risk tolerance, age, income requirements, and long-term investment goals.
To learn how Marc J. Lane Investment Management, Inc. can help you develop and implement the best investment strategy based on your own objectives, please call Marc Lane at 312-372-5000 or email him in confidence at mlane@MarcJLane.com.
Kenneth N. Green is Senior Vice President and Director of Investment Research for Marc J. Lane & Company and Marc J. Lane Investment Management, Inc. Mr. Green is a graduate of the University of Michigan (M.B.A.) and the University of Illinois at Urbana (B.S.). Mr. Green is also a Certified Public Accountant (CPA).
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