As the third quarter of 2018 comes to an end, we are reminded that the world is ever-changing, markets are increasingly global, and patient investing remains critical to long-term success. The key headlines for the third quarter included continued dominance of U.S. stocks, increased strength of the U.S. dollar, rising interest rates, questions about the relationships with our foreign allies and foes, and a plentiful supply of political news. Although the rise of the U.S. stock market seems impressive (the S&P 500 Index notched its best quarter in nearly five years), it is important to note that most of the gains came from a handful of the largest U.S. companies. In fact, if you removed the performance of the technology sector within the
S&P 500 Index, the overall return of the index would be rather modest, not too dissimilar from what happened in the late ‘90s. Foreign stocks trailed their domestic brethren for the fourth consecutive quarter, while concerns lingered over tariffs and the strengthening U.S. dollar. With the long-expected and continued rise in interest rates, bonds again provided uninspiring returns, albeit still serving as risk-reducing ballast for portfolios and providing hope for higher yields going forward.
Asset class returns for the quarter and year-to-date were as follows:
|Barclays U.S. Govt./Credit—Int.||Fixed Income|| |
|S&P 500||Large U.S. Stock|| |
|Russell 2000||Small U.S. Stock|| |
|MSCI ACWI ex-USA||Foreign Stock|| |
|S&P Global REIT||Real Estate Securities|| |
With the S&P 500 Index up nearly 8% for the quarter, and over 10% since the beginning of the year, many investors may be surprised to find that their globally-diversified equity portfolios attained only low-to-mid single-digit year-to-date returns. This outcome may call into question the value of investing outside of the U.S. stock market. With the U.S. stock market notching fresh new highs, why would investors allocate a sizeable portion of their portfolios to foreign stock markets, which have lagged since the market lows of 2008-2009? In this quarter’s letter, we thought it would be helpful to discuss why our client portfolios include an allocation to both domestic and foreign assets.
For decades, the primary rationale for investing in foreign stocks has been to improve overall portfolio diversification, which both reduces risk and improves returns. Due to variances in economic growth and other factors among countries, foreign stocks tend to be less than perfectly correlated with U.S. stocks, thereby improving the risk/return profile of the overall portfolio. Even with the growing interconnectedness of the worldwide economy, we continue to firmly believe that foreign stocks deserve a home in a broadly-diversified portfolio, perhaps more so now than in the past several years. With approximately 48% (and growing) of the world’s equity investment value found in non-U.S. companies, U.S. investors miss out on approximately half of global investing opportunities if they shun foreign-based companies. In addition, much of the world’s economic growth will continue to come from outside the U.S., a trend that has accelerated significantly over the past decade. As reported by the International Monetary Fund, emerging countries like India and China are expected to grow at rates nearly double that of the U.S in 2018. (Source: www.imf.org, IMF DataMapper, 2018)
The U.S. equity market has had strong performance relative to other developed countries for much of the last decade, but has been the top performer amongst developed countries just once (2014) in the last 20 years. As highlighted in the chart below, $1 invested in a global balanced equity strategy turned into $478 from 1970 to 2017. By comparison, the same $1 invested in the S&P 500 Index turned into $122 over that time period. Will the strong U.S. performance streak continue over the long-term? It is impossible to say at this point, but the recent trend of a U.S.-only portfolio outperforming a globally-diversified portfolio is unlikely to continue based on experience over the past 50 years. Since predicting which global market will perform best in any given year is impossible, we believe patience and diversification are essential.
Dowling & Yahnke invests in foreign markets through low-cost mutual funds and exchange-traded funds. We generally split foreign stocks into two categories, developed markets and emerging markets, with a larger weighting in the former. Developed countries, like the United Kingdom, Australia, Japan, and Canada, typically have democratic political systems, established financial markets, relatively high per capita incomes, and a general openness to foreign trade and investment. Emerging countries, like China, Brazil, India, and Mexico, are deficient in one or several of these traits. As you move across the spectrum from developed markets to emerging markets, investment risk generally increases. Investors, therefore, bear greater investment risk in emerging markets compared to developed markets. Because of their higher risk, and their generally higher growth rates, investors would expect emerging markets to produce higher long-term stock returns than developed markets. Although we consider foreign stock investment to be fundamental to long-term investing, Dowling & Yahnke does have a “home bias” in our portfolios because we live and spend in the U.S., meaning we hold a larger allocation to the domestic market than a market-weighted global portfolio would dictate.
While foreign investing can greatly improve diversification, it certainly cannot eliminate all risk. Global diversification helps protect portfolios against risks specific to a particular company, industry, or country, but does not protect against systematic risks, such as war, political turmoil, or similar events that impact global financial markets in general. The value of diversification should not be judged over short periods of time, and foreign investing can certainly leave investors feeling frustrated at certain points in market cycles. However, diversification remains an essential tool for improving returns and reducing risk in investment portfolios. It is Dowling & Yahnke’s belief that the key to long-term investment success is to build globally-diversified portfolios in the most cost effective and tax efficient manner, taking into account each investor’s willingness to accept risk and need for liquidity.
October is proving to be an exciting time here at Dowling & Yahnke. We have very much been looking forward to sharing a few announcements with you.
Dowling & Yahnke Wealth Advisors
12265 El Camino Real, Suite 300
San Diego, CA 92130
Note that our telephone and fax numbers will not change.
While our guiding principles remain the same, we are confident these updates will lead us into the future with our clients. We invite you to contact our team with any questions or concerns regarding your finances.