Quarterly Investment Commentary
The persistent advance of U.S. stocks was not slowed down by the Federal Reserve’s decision to start winding down its bond buying program. Equity markets finished in positive territory in the 4th quarter and many U.S. stock indexes ended the year at record highs. U.S. large companies advanced 10% for the quarter and 33% for the year, while small company stocks were up 8% for the quarter and 38% for the year.
It was a wild ride for bond investors in 2013, and the 4th quarter didn’t let up. Interest rates, as represented by the ten-year treasury yield, advanced to 3.03% after starting the year at 1.76%. Bond prices move inversely to interest rate changes, thus U.S. taxable bonds and municipal bonds finished down about -2% for the year.
In mid-December the Federal Reserve announced that they will slightly reduce purchases of mortgage-backed and longer-term Treasury securities starting in January. The committee cited continued improvements in economic activity and the labor market coupled with benign longer-term inflation expectations.
The U.S. economy ended the year on a positive note with continued measured improvements in the labor market, corporate profits, housing and consumer sentiment. 3rd Quarter GDP was revised upward to a robust annual rate of 4.1%.
Outside the U.S, the results were mixed with foreign developed markets advancing 22.8% for the year, while emerging markets declined -2.6%. Emerging markets actually would have finished up 3.8% if not for currency weakness versus the U.S. dollar. Growth across the major emerging market countries slowed to 5.4% after averaging 7.2% from 2006 – 2011.
Headed into 2014, it is likely that the Federal Reserve will continue to reduce asset purchases especially if the U.S. economy continues to improve.
Q4 2013: Maintaining Perspective
Investors will remember 2013 as the year the Dow Jones Industrial Average and S&P 500 hit record highs. While the U.S. markets did extremely well, other global markets struggled mightily, such as the 6th largest global economy of Brazil, with their financial markets down over 15%. Bonds also did poorly last year, down 2%. This wild divergence of returns may leave investors to ponder if maintaining the same diversification structure makes sense. It is natural to ask such questions. From our perspective, 2013 was indeed a success. This quarter we will focus on the best recipes for longer-term investment success, and explain what we will do in 2014 to add value in your portfolio.
2013 In Review: A Disappointment or Better than Average?
When investors review their quarterly and annual results, they may find themselves asking why the overall return they experienced likely does not match the U.S. equity markets that are up 33%. The simple explanation is that most investors do not only own U.S. stocks. While we always recommend clients have exposure to U.S. stocks, this exposure is typically between 30-40% of a client’s overall portfolio, depending upon their comfort with exposure to riskier assets. The rest of it is allocated to foreign equities, bonds, and other diversifying strategies. While it may be disappointing to have captured only a portion of the US stock market’s return, the average returns our clients received this year were higher than we would typically expect for an all-risk 100% Equity portfolio to provide on average. Also, it is important to remember that this knife cuts the other way sometimes too. In a year like 2008 when U.S. stocks were down by 37%, a well-diversified portfolio fared much better than the stock market did.
Over the last few years investors appear to have built an expectation that asset categories should perform similarly to one another from year to year. This may be explained by the fact that asset class categories performed more closely with one another from 2010 – 2012 than they normally do. The difference between the highest and lowest performing asset class category each year over this time period was around 28%, which is narrower than the 10-year historical average performance difference of 43%. In 2013 we saw a 48% range between the best performing asset category and the worst performing, so it was actually a somewhat normal year in terms of the average, but it had nearly double the dispersion of the preceding three years. To boil it down, a year like 2013 does not surprise us because we know that divergent performance between various asset class categories in any one year is quite normal. For a better understanding of the year though, let’s dig into each asset class in more detail.
Global Equities: The table at right shows performance for the asset class categories that we include in global equity portfolios. We blend these categories together to build Paracle’s equity portfolio, with the goal of optimizing return relative to risk. Paracle’s equity portfolio weights U.S. Large Cap and Foreign Small Cap more heavily than the global weighted MSCI All Country benchmark, which helped our portfolios perform well this year. Although we generally don’t like to make comparisons on a calendar year basis because our process is designed for long-term success, we are pleased with the performance of our equity portfolio this year relative to its benchmark.
Fixed Income: As one would expect in a year where interest rates have increased by a meaningful amount in anticipation of economic growth, it’s no surprise to see bonds finishing in negative territory. Our emphasis on intermediate-term exposure helped mitigate further declines while still maintaining competitive yields. Many bond experts feel that rates have moved more than half way to where they should be in relation to GDP growth, and they estimate that 10-year Treasury yields will settle out somewhere between 3.0 to 3.5%, which is quite close to its current level of 2.9%. While we know that even the experts are often wrong when trying to predict interest rates, if this turns out to be correct, then a great deal of the pain of interest rate adjustments is already behind us.
Non-Traditional: The table shows that some asset class categories included in our non-traditional portfolios did well, while others struggled. This is one reason why we include a wide variety of diversifying exposures. Our objective for the non-traditional portfolio is to include exposures that behave differently than either traditional bonds or equities.
Will the Top Asset Class Please Step Forward?
As a mental exercise, try to estimate which category you think will perform the best in 2014. How will you go about this? Will you visit financial forecasts from pundits or financial publications? Will you study recent performance for various investments to try to look for a predictable pattern?
Many investors cling to a belief that it is good strategy to attempt to predict which asset class will have the highest return for the year ahead and then allocate a large amount of their portfolio to it. It is no wonder that people aspire to this, since many financial articles make these sorts of predictions and openly encourage this type of thinking. In reality though, these forecasts are seldom on the mark, and a tactical strategy of moving assets around based on market forecasts only works if you have the ability to accurately and consistently predict the future.
To demonstrate just how unpredictable the markets are, and how dangerous this game is, the table to the right shows asset category returns for each calendar year over the last 10 years. Take a look and see if you can find any consistent patterns. We don’t see any. Investors may get their guesses right sometimes, but not often enough to achieve successful outcomes. In fact, studies show again and again that investors have a strong tendency to choose a category which has outperformed recently, only to discover that this asset category is not performing as well this year as it did last year. So they move on, over and over in an endless cycle of chasing “hot” sectors. In the end, according to a study by Dalbar Inc. they achieve returns of 2% on average, whereas simply investing the money and not moving it around at all would have produced much higher returns.
We don’t have the ability to predict the future, nor do we try to pretend that we do. We contend that it is better to be honest rather than to weave a wonderful tale. You will note that our market summaries never make short-term market predictions. We focus on stating what we know rather focusing on what cannot be known.
So what to do? If we are candidly unable to identify the best-performing asset class, is hope lost? No. There are better, smarter ways to achieve investment success. Let’s explore some time-tested practices that lead to success.
Steady vs. Stellar
We prefer consistent performance generated through exposure to a variety of asset class categories rather than chasing top performance in any given year. Why? The reason is simple: The beauty of compounding returns. Gains upon gains add up better than occasional stellar performance. The example below illustrates two different portfolios. Both achieved the same average annual return, but with different return patterns. The growth of $1,000,000 over a ten year time period clearly demonstrates that the less variable portfolio wins, so it is easy to conclude that the better portfolio is the one with greater consistency rather than occasional top performance.
Buy and Rebalance
According to a study by Russell Investments, a disciplined approach to rebalancing can add anywhere between one-half a percent to a full percent of return. While this may not seem like much, it adds up over time. Although rebalancing may seem like a no-brainer concept on its face, it is often the hardest thing to do in psychological reality. In our rational minds we believe rebalancing is a great idea because it forces the time-tested discipline of buying low and selling high. Said another way, rebalancing involves selling the thing that has performed well recently and buying the thing that hasn’t performed well. Let’s be honest. It never feels natural to actually do it. It’s a matter of discipline and a battle of will.
One way we help our clients is by providing education that helps to protect against the natural urge to make decisions based on emotions. When bonds underperform equities, it’s natural for an investor to want to shift toward equities. The rationale ranges from nervousness about rapidly rising interest rates (i.e. wanting to avoid bonds) to just plain getting tired of seeing their total portfolio returns trail the S&P 500. Making investment decisions based on most recent experience is not optimal. Case in point, in 2008 when financial markets fell rapidly, many investors wanted to trim equities. At that time some investors chose to move out of stocks, or at least not to buy more stocks to rebalance their allocations. Investors who did not purchase equities in 2008 and early 2009 missed out on better returns.
Also, specifically with regard to wanting to avoid bonds, let’s revisit the basics of investing: Bonds receive a frequent income payment and have a stated maturity value. Stocks on the other hand, may pay income in the form of dividends but they do not have a stated ending value. Because of these characteristics, stocks are riskier and have declined at a much greater magnitude historically than bonds. Over the last 20 years the worst calendar year return for bonds was -3% versus -37% for stocks.
Rebalancing makes as much sense now as it always has.
Adding Value in 2014
It is easy to lose sight of the importance of investment basics when equity markets advance at a rapid pace, and it is tempting to chase return. Our goal is to maintain discipline and focus, which guides us to take the risks necessary to achieve your goals and satisfy your longer-term return desires, but not to take on extra risk that could be regretted if markets retract. In 2014 we will continue to do what we always do:
- We will plan carefully and calibrate your portfolio’s asset allocation to satisfy your cash flow needs, return requirements, and preferences.
- We will seek consistent returns through broad exposure to a variety of asset class categories.
- We will rebalance when it makes sense to do so, even if it seems counterintuitive at times.
Yes, we know you’ve heard this all before. But the simplest things can be the hardest to remember and act upon, and it is for this reason that we take the time this quarter to revisit the basics of successful investing.
We hope that you find these perspectives helpful and are pleased to discuss any aspects that you would like to cover in greater detail.