Two months past New Year’s Eve and it’s quite likely your own “resolutions” are merely well-intentioned memories. It’s not easy to resist temptation and some might ask why, indeed, they should. Investors may have been tempted, for example, to eschew equities entirely after global stock prices crashed in 2008. However, for those who kept their resolve and their wits about them, they benefited from the past few years, which saw stock prices soaring, eventually rising even past their pre-crash highs.
About this time last year, investors questioned why they should hold onto bonds. Indeed, financial writers insisted that the timing was all wrong for bonds, that the Fed was about ready to rein in stimulus, that bond yields were too low relative to inflation, and that “bond substitutes” were the way forward. In fact, in 2014, interest rates fell and bond prices rose, to nearly everyone’s great surprise, with the Barclays Aggregate Bond Index returning 5.8%. Investors who had succumbed to the temptation of “bond substitutes” were left licking their wounds.
The mistake, or perhaps misconception, of “recency,” as discussed in this post, occurs when investors give greater weight to recent information than the long-term evidence warrants. This, in turn, leads investors to buy after periods of strong performance and sell after periods of poor performance, the diametric opposite of every investor’s mantra, to ”buy low and sell high.” It also results in investors doing the opposite of what they should be doing, namely rebalancing in order to maintain their portfolio’s asset allocation.
This year, even as we acknowledge that both stocks and bonds deserve a place in a well-diversified portfolio, many investors are asking whether some stocks should be avoided. Specifically, they wonder why, in this uncertain global climate, should they be holding onto international stocks. That’s a good question; last year, U.S. investors of international stocks, primarily large companies in Europe and Asia, fell by an average of 6% while emerging market stocks tumbled by 8% on average. At the same time, the S&P 500 Index, driven, of course, by large U.S. companies, returned 13.7%.
The reason for negative returns on the indices wasn’t because those international companies were mismanaged, and it wasn’t due to the threat of deflation. In fact, overall, the performance of those foreign companies was generally strong. The trouble for U.S. investors was currency fluctuations. In “local” currency, some foreign indices returned figures that equaled or even bested the S&P 500, but when the currencies were converted into U.S. Dollars, the almighty greenback walloped its weaker peers.
Of course, currency fluctuations can cut both ways and can boost international stock returns when the U.S. dollar lags other currencies as is happening now. The simple fact is we don’t know where currencies will move next, and a surprise in fundamental data, good or bad, can occur at any time. That surprises can happen is about the only certainty when it comes to any financial market, and that is itself sound rationale for investment diversification.
As Larry Swedroe points out, “Investing in international stocks, while delivering expected returns similar to domestic stocks, provides the benefit of diversifying the economic and political risks of domestic investing. There have been long periods when U.S. stocks performed relatively poorly compared with international stocks.”
Why should investors hold last year’s underperformers? Simply because if you don’t have an underperforming asset class in your portfolio, it most likely means that you’re not well diversified. Going forward, you will tend to be more affected by certain economic downturns than your more diversified peers.
Of course, that’s not to say that diversified investors don’t face risks each year; they do, but they’re often of their own making. Time and again, investors have to persuade themselves to stay the course, within their own disciplined investment strategies, even as friends and neighbors brag about their more concentrated bets. Even positive investment returns can be a disappointment, if they’re less positive than someone else’s. The temptation to judge our own progress by comparing ourselves to others is, of course, simply human nature.
For individual investors, financial goals should be defined in terms of individual timeframes and risk tolerance, not abstract aspirations to “make more” or “do better than” someone else. Investors who cultivate this point of view, resisting the temptation to alter their portfolio allocations based on recent ebbs and flows, are far more likely to reach their long-term goals.