If your returns were poor last year, you were in good company. The S&P 500 gained only 4.9% and the Dow was down 1.4%. Indexes, however, are poor indicators of what wisely invested balanced portfolios should return. A better diversified portfolio would have earned over 10% in 2005.
Many investors and advisors view asset allocation as the investment mix between stocks and bonds. The stocks selected are usually US large-cap, and the bonds are also all US. Since US bonds returned about 2.4% and US large-cap returned a paltry 4.9%, no asset allocation mix between the two could produce a return better than about 5%.
We recommend a much more diverse asset allocation. Domestically, mid-cap was the place to be this year. The S&P 400 MidCap Index returned 12.4% and the Russell 2000 (small-cap) returned 8.1%. A mix of mid and small-cap historically beats large-cap and often provides a boost to returns. Taken by themselves they are more volatile, but as a smaller portion of a broad asset allocation they actually reduce volatility. Reducing average volatility while increasing average returns is a win-win proposition diversified investors enjoy.
Overall, value funds (7.8%) beat growth funds (6.4%) this year but among mid-cap stocks, mid-cap growth funds (16.3%) beat mid-cap value funds (11.5%). Although mid-cap growth funds beating mid-value funds was the exception last year, it teaches an important investment lesson: diversification over all of the investment styles helps smooth and boost returns. No one can predict the future.
US stocks and US bonds are just two of the six major asset classes we use for diversification. Foreign stocks, foreign bonds, and hard asset stocks are the three categories most commonly underrepresented in most investor’s portfolios.
One of the biggest factors in foreign investing during 2005 was the strengthening of the US dollar against foreign currencies as the Federal Reserve raised interest rates. In past years, foreign investments benefited from the value of the dollar dropping against foreign currencies. This year reversed that trend and the Dollar Index was up 12.6% for the year. Normally this would mean that foreign investments would lose 12.6% in terms of US dollars. This, however, did not dampen foreign investments much.
Foreign Bonds, which performed well over the past few years lost only 3.2% during the year. Foreign stocks faired much better.
The MSCI EAFE international index gained 26% in countries’ local currencies and (only) 10.9% in US dollars. The 15% difference between local currencies and US dollars is because the Euro lost more against the dollar than other currencies. Emerging market currencies, on the other hand, did not lose as much against the dollar.
The MSCI Emerging Market Index gained 31.5% in local currencies and still gained 30.3% in US dollars. The currencies of emerging market stocks held their value against the US dollar much better than the currencies of developed nations. This is the second year that emerging markets have produced large gains.
In summary, the indices most people listen to on the news each day were the bellwether of nothing worthwhile. The smart investors last year were diversified across multiple sectors and globally invested.
Review the asset allocation of your investments. We suggest expanding your investment mix to include foreign stocks, foreign bonds, and hard asset stocks. Adding these to a diversified portfolio of US stocks and bonds will reduce the average volatility of your portfolio while boosting returns.
Photo by Vincent van Zalinge on Unsplash