The Forest for the Trees

Market returns year-to-date make diversified portfolio investors question their approach.
By: Allie Schmidt, Financial Advisor, CFP®, CPA

Living in the US, domestic indices such as the S&P 500, the DOW, and the NASDAQ pretty much dominate the focus of financial markets in the media.  These are the numbers that appear at the bottom of your local news broadcast or scrolling across the top of Yahoo Finance and the Denver Post.  This type of focus can mislead investors as to how their portfolios should, or in fact, are performing.

Most prudent, diversified portfolios are comprised of at least 3 broad allocations: domestic stocks, international stocks, and US bonds.  This is in line with the long-standing idea of essentially not putting all of your eggs in one basket.  This makes sense, and despite feeling like the center of the world – the domestic market only makes up about 50% of the global economy.

CHART A

Diversified portfolios are not a new concept.  You can quickly find a variety of textbooks, blogs, economists, and investment experts that continue to write and speak on the importance of diversification in every investment portfolio.  However, these last 9 months have left even the most faithful diversified portfolio investors questioning their approach.  Year to date market returns have varied substantially across those 3 basic allocations.  Chart A looks at a comparison of 3 broad indexes, the US market (S&P 500 index), the international market (MSCI EAFE index), and the US bond market (Barclays US Agg Total return index).  You can see a large bifurcation between international and domestic stocks near the beginning of June when concerns of trade wars and currency volatility increased and continued to weaken most recently surrounding concerns in Turkey.  Ultimately leading to a spread of 14.50% between the return of the MSCI EAFE and the S&P 500, this in addition to a slightly negative US bond market due to increasing rates leading to negative pricing pressure (-1.40%).  This chart speaks volumes as to why diversified portfolios are likely flat to slightly positive year to date.

But, before you jump off the diversification train or start to sell low and buy high chasing returns, let’s look at a couple other time periods.

CHART B

Remember the beginning of this year when the domestic market dropped by 10% in just a couple weeks?
I remember reading a headline on CNBC referring to the “Dow bloodbath” wow that language sells…
I certainly clicked on it! The Dow was down about 5% at the time.  Chart B  on the left looks at that time frame and you can see your diversified portfolio (depending on allocations) likely outperformed both the domestic and international stock markets because of the safety measures of US bonds. 

One final look, calendar year 2017, Chart C, where international stocks outperformed the increasing S&P 500 by more than 2%. From a valuation standpoint, it’s hard not to see the value of international stocks compared to our domestic market, with a P/E ratio of the MSCI EAFE of 15.51* vs the S&P 500 of 25.24**.

CHART C

You can see that overtime, each of these sectors have taken their turn at the top.  This is just looking at the past 20 months or so, but these trends continue over decades.

Research has proven that diversified portfolios over time are essential to meet investor’s various goals, however, at any point in time can create frustration.  A flat investment portfolio year to date is a great example.  When stock markets (domestic or international) breakout to double digit returns, due to the safety measures in your portfolio, you’ll likely be slightly below those returns, and when stocks markets (domestic or international) decline, your portfolio will likely still be negative, just not down as much.  This can be incredibly frustrating at any point in time, however, over time a well-managed diversified portfolio can provide higher average, less volatile annual returns.  In order for investors to see the forest for the trees, they must stay diligent and remember to look past the headlines to focus on their long-term goals.

*According to msci.com.
**According to multpl.com

Chart source: YCharts

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of recommendations for any individual. All performance referenced is historical and is no guarantee of future results. The opinions expressed in this material do not necessarily reflect the views of LPL Financial. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. All investing, including stocks, involves risk including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors. The S&P 500 is a stock market index that tracks the 500 most widely held stocks  on the New York Stock Exchange or NASDAQ. All indices are unmanaged and may not be invested into directly. Any named entity, HD Wealth Strategies, and LPL Financial are not affiliated. This information is not intended to be a substitute for specific individualized advice.