By Christopher W. Beale, CFP®
The end of one year and the beginning of another is a good time to measure progress. The typical bench mark for measuring performance in our industry is the Standard and Poor’s 500 (S&P 500) which is an index of the 500 largest U.S. based public companies. Many people still use the Dow Jones Industrial Average (DJIA) as the stock market benchmark. The DJIA uses 30 large U.S. companies for this index. According to the Wall Street Journal, for 2014, the S&P 500 returned 11.4% and the DJIA returned 7.5%. If you’re wondering how your account did compared to these benchmarks you might see an underperformance this year. There may be many reasons for this but I think the main reason many of our model portfolios at New England Capital didn’t keep up with the S&P 500 and the DJIA can be summed up in one word: diversification.
None of our portfolios invest in 100% large U.S. companies exclusively. Instead we invest not only in large U.S. companies, but small and midsize U.S. companies. We also invest in large and small foreign companies both in developed countries as well as companies in emerging markets countries such as India, Brazil, and China. Most portfolios will also include bonds which typically react differently than stocks, again for added diversification. We even have diversified our bond holdings by using U.S. government bonds, Treasury inflation protection bonds, foreign bonds, high yield bonds and municipal bonds. Cash or Money Market investments are a great diversifier to reduce risk and increase stability. Commodity funds, real estate funds and long/short funds are also used to increase diversification and reduce volatility.
Diversification, by definition, means investing in multiple asset classes. We want different parts of your account to zig while others zag. Fortunately, this typically helps our long term performance by smoothing out returns, reducing volatility and downside risk in your accounts. Unfortunately this great, prudent, long-term approach to managing money can make us look silly in the short term when we compare how we did verses a signal asset class like large U.S. stocks.
So your portfolio may not have “beat the market” as defined by the S&P 500 because parts of your portfolio underperformed compared to the S&P 500 in 2014. Specifically the Russell 2000 (small US companies) up 3.5%; EAFE (foreign stocks excluding the U.S.) down 7.4%; EAFE EM (emerging market stocks) down 4.6%; S&P GSCI (the commodity index) down 33.1% -- but at least we are paying less money to fill our gas tanks. Finally, the cash position in New England Capital model portfolio’s effectively had a 0% return which also dragged down our overall returns. Of course, your real estate fund returned more than 30% in 2014. So why didn’t I just have all your money in that fund in 2014? First, I’m still perfecting my super human powers of seeing into the future, and secondly, I have a fiduciary responsibility to act prudently on your behalf which couldn’t be justified by concentrating 100% of your money in one asset class.
An interesting thing happens when we look past a 1, 2 or 3 year time frame. When we review a full market cycle or a 10 year period, a well-diversified portfolio which reduces volatility and downside risk can actually outperform most individual asset classes. Also, while discussing goals with you, no one ever mentions “beating the market” as your goal. Our conversations with you center around three broad goals: accumulation of real wealth, protection of wealth, and the efficient distribution of wealth.
Please understand that we at New England Capital have extensively reviewed and studied our absolute and relative performance this year for lessons on how we can build our model portfolios and manage your money to serve you better. I can safely say that diversification will continue to be a key aspect of how we manage money this year and into the future. The main point of diversification is that no one knows with certainty what tomorrow has in store for us. Market timing, which we don’t practice at New England Capital, implies knowledge and certainty about the future. This is the essence of diversification. As we begin this New Year, none of us knows whether stocks will outperform bonds, whether the U.S. or Europe or China will end the year in positive territory. Holding some of each is a prudent strategy since one can never predict these things in advance.
What I do see is a kind of boring, long, slow economic recovery in the U.S., a slow housing recovery and healthy, but not spectacular job creation. I see a less healthy Europe and stagnation and fear in southern countries of Europe, including Greece who will hold a national election for a new government this month. The steep drop in oil prices from $107 per barrel in July 2014 to less than $50 per barrel as I write today will save approximately $14 billion to U.S. drivers annually, but hurt oil exporting countries like Russia, Venezuela, and some mid-east countries.
I also know that since 1875 the S&P 500 has never risen for seven consecutive calendar years. Could 2015 break the trend? I will be watching closely because it will make for a good story in January 2016. But of course I will be less interested in how one asset class does in any one year, as I will be interested in achieving your life goals.