Should you change your investments according to which party wins a majority on Capitol Hill? History shows that markets have rewarded investors, no matter who controls Congress.

Financial innovation provides investors with a seemingly endless supply of new investment options. But the process of evaluating the merits of these investments remains the same even as the names change. Adopting a new component in one’s asset allocation represents a tradeoff that should carefully balance the expected benefit vs. the cost of its inclusion. The following framework highlights benefits investors may seek as well as potential drawbacks—a checklist that applies to any investment opportunity.

STARTING ON A ROLE
Properly evaluating whether something belongs in your portfolio begins with specifying the role it is expected to play. These roles come down to a) increasing your expected return or b) helping manage risk.

If the objective is to increase expected returns, what is the case for the asset in question accomplishing that? It is easy to link a positive expected return with equities, for example, as stock ownership gives you a claim on companies’ future cash flows. Similarly, bondholders expect to receive periodic interest payments and the return of their principal as stipulated in the bond’s covenant. But an asset that lacks a sound foundation for delivering a positive expected return should give investors pause, regardless of its past performance.

Investors should also be wary of making assessments about expected returns in asset classes with limited data. Newer products with shorter track records give investors less information about what to expect in an asset class. Non-publicly traded investments may pose additional hurdles due to a lack of timely market-based performance data. And, finally, the age-old difficulty in distinguishing between luck and skill is amplified in more- volatile asset classes.

Expected return may take a back seat in the case of an asset that helps manage risk. Professor Ken French defines risk as uncertainty about lifetime consumption. This uncertainty stems from many sources, including market downturns, inflation, and interest rate changes, to name a few. Risk- management assets should offer a robust way to mitigate the contributions from one or more of these contributors to uncertainty.

Investors should avoid “missing the forest for the trees” when hedging risk. For example, an asset class whose returns are correlated with inflation but are much more volatile than changes in the Consumer Price Index may not be an effective risk-management tool. You may be hedging unexpected inflation but still increasing uncertainty over future consumption due to the volatility.

Investments may also reduce portfolio risk if they increase diversification. But how should investors assess the diversification benefit? Although it is common to look at noisy correlation estimates, investors may want to ask whether the investment expands their opportunity set. If you’re only invested in US stocks, then expanding the portfolio globally improves diversification. The global stock market is worth around $80 trillion.1 Global bond markets tack on another $125 trillion.2 This is important context for the size of potential additions to your asset allocation and may be a helpful starting point for determining how much to invest in the asset.

THE COST OF DOING BUSINESS
The benefit of adding something to your portfolio must outweigh the drawbacks.
An obvious drawback is high costs. Fees and expenses are typically transparent to investors, but it’s important to be aware of differences in fee structures. Traditional equity and fixed income mutual funds and ETFs usually use a flat percentage fee based on assets under management. Other asset classes may include performance fees. These structures may incentivize manager behavior in ways that are inconsistent with your investment objectives.

A less-transparent cost (at least on expectation) is the potential for adverse selection. Whether we’re talking about the latest initial public offering (IPO) or a private equity placement, the most desirable allocations will have a line out the door. Investors without access to the most desirable investments will be left with suboptimal selections. This challenge is compounded if high minimum-investment thresholds are imposed, which may preclude diversified exposure across investments.

An investment’s potential is more likely to be beneficial if you can stick with it through thick and thin. This is where complexity becomes a drawback. All investments go through periods of disappointing performance. The extent to which investors can endure these periods and stick with the investment plan may depend on how well they understand what drove performance. Transparency and trust tend to be highly correlated. All else equal, investors in opaque strategies or ones with less operational history may be less inclined to persevere in times of uncertainty.

Finally, there’s the cost of wondering about the road not traveled. Adding a new investment means giving up some of what you already have. That presents the potential for regret if the asset you’re giving up goes on a strong performance run subsequent to the change. For example, many investors were tempted to jettison value portfolios in the wake of value stocks’ decade-long underperformance vs. growth prior to 2021. Replacing value right before its historic run in 2021 and the first half of 2022 may haunt investors for years to come.

REAL-WORLD EXAMPLES
We can put this framework to use with a few examples of notable alternative asset classes.

Bitcoin
The media fanfare around has left many investors wondering if they should dip their toe in the cryptocurrency waters. A few aspects of our evaluation framework are instantly relevant.

Let’s start with the expected-return criterion. Little attention would be paid to bitcoin were it not for its meteoric rise in value in recent years.3 But it’s unclear why holding bitcoin should have a positive expected return. Bitcoin offers no claim on future cash flows, as one gets with a stock, and no promised interest payments, as one is entitled to with a bond. Future returns from simply holding bitcoin depend on it appreciating in value vs. another asset—the definition of a speculative investment.

It's also not clear bitcoin or other cryptocurrencies can help investors manage risk. Using Professor French’s definition of risk, it is difficult to imagine uncertainty over lifetime consumption being reduced by an asset that has, multiple times, fallen in value by double-digit percentages in a single day.

Another consideration is the size of the bitcoin market, which, at around $384 billion,4 is about 0.2% of the market value of global stock and bond markets. To put that in perspective, a $1 million portfolio composed of global stocks, global bonds, and bitcoin at market-cap weights would hold only about $2,000 in bitcoin.

Managed Futures
Managed-futures funds typically hold diversified futures contracts tied to various stock and bond indices. These strategies are often touted as diversifiers for traditional asset classes. While they may have low correlations with traditional equity portfolios, it is not because they expand an investor’s opportunity set; futures contracts are derivatives whose value is determined by the performance of the underlying asset. Derivatives may alter the so-called payout function of the asset, such as reducing downside exposure by forfeiting some potential upside, but they generally do not offer exposure to asset classes outside of traditional portfolio components.

Costs are another consideration with managed-futures strategies. An academic study5 on managed-futures funds reported a gap between before-fees and after-fees measures of average returns of 4.52 percentage points per year. That’s a lot of performance being squeezed out before it can land in an investor’s hand.

Thematic Funds
Thematics represent a broad class of investment strategies that generally target themes, providing exposure to narrow subsets of the market, such as individual sectors or companies touted as potential beneficiaries of long-term economic trends.

Proponents of thematic investing may subscribe to a high-expected-return story rooted in the premise that these investment styles are ahead of the curve. This is essentially a market-timing proposition, and the historical data are not kind to the success of market timing. Thematic funds therefore may not increase expected returns for investors already possessing exposure to the equity market.

It’s also not clear thematic strategies increase diversification. For example, one thematic ETF focuses on companies expected to benefit from COVID-19-related paradigm shifts (work from home, attention to health, etc.). These aren’t new sectors—investors with globally diversified equity portfolios are likely holding these stocks already. 

ASKING THE RIGHT QUESTIONS
Type I errors in asset allocation changes are expensive. Replacing an investment you once believed in with a shiny new product that doesn’t pan out is potentially detrimental to achieving your financial goals. A consistent evaluation framework helps investors mitigate the chance of this regret. These evaluation criteria can also be customized to individual preferences. After all, considerations like liquidity needs and risk tolerance often vary through an investor’s lifetime.

At the end of the day, this framework is about asking the right questions, which, as researchers will tell you, is just as important as the answer itself. 

On May 4, the US Federal Reserve increased the target federal funds rate1 by 50 basis points as part of what the central bank said will be a series of rate increases to combat soaring inflation in the US. Some investors may worry that rising interest rates will decrease equity valuations and therefore lead to relatively poor equity market performance. However, history offers good news: Equity returns in the US have been positive on average following hikes in the fed funds rate.

We study the relation between US equity returns, measured by the Fama/French Total US Market Research Index, and changes in the federal funds target rate from 1983 to 2021. Over this period of 468 months, rates increased in 70 months and decreased in 67 months. Exhibit 1 presents the average monthly returns of US equities in months when there is an increase, decrease, or no change in the target rate. On average, US equity market returns are reliably positive in months with increases in target rates.2 Moreover, the average stock market return in those months is similar to the average return in months with decreases or no changes in target rates.

​
EXHIBIT 1 Reliably Rewarding
US equity market returns and fed funds target rate change, January 1983–December 2021

What about the months after rate hikes? This question may be of particular interest when the Fed is expected to increase the federal funds target rate multiple times. Exhibit 2 presents annualized US equity market returns over the one-, three-, and five-year periods following one or two consecutive monthly increases in the fed funds target rate, as well as following months with no increase. In reassuring news for investors concerned with the current environment of increasing rates, the US equity market has delivered strong longer-term performance on average regardless of activity at the Fed.


EXHIBIT 2 Keep On Keeping On
US equity market returns following consecutive fed funds rate hikes, January 1983–December 2021

​With a number of Federal Open Market Committee meetings remaining in 2022, the Fed’s signals and actions will continue to be closely watched by the market. As the Fed often signals its agenda in advance, we believe market participants are already incorporating this information into market prices. While it’s natural to wonder what the Fed’s actions mean for equity performance, our research indicates that US equity markets offer positive returns on average following rate hikes. Thus, reducing equity allocations in anticipation of, or in reaction to, fed funds rate increases is unlikely to lead to better investment outcomes. Instead, investors who maintain a broadly diversified portfolio and use information in market prices to systematically focus on higher expected returns may be better positioned for long-term investment success.

​

After a strong year for the value premium, investors are curious about what that means for value performance for this year. 

​
ANNUAL VALUE PREMIUM AND FOLLOWING YEAR VALUE PREMIUM
US Market, 1927–20211 

​Investors haven’t missed the boat. Staying consistent in your exposure to the value premium can be the most reliable way to capture long-term returns. 
​

​How quickly things change.

Two years ago, the New York Times reported, “Federal Reserve officials are increasingly worried that inflation is too low and could leave the central bank with less room to maneuver in an economic downturn.”1 More recently, a Wall Street Journal article presented a sharply different view, with a headline that likely touched a raw nerve among investors: “Everything Screams Inflation.” The author, a veteran financial columnist, observed, “We could be at a generational turning point for finance. Politics, economics, international relations, demography and labor are all shifting to supporting inflation.”2

Is inflation headed higher? In the short term, it has already moved that way. With many firms now reporting strong demand for goods and services following the swift collapse in business activity last year, prices are rising—sometimes substantially. Is this a negative? It depends on where one sits in the economic food chain. Airlines are once again enjoying fully booked flights, and many restaurants are struggling to hire cooks and waiters. We should not be surprised that airfares and steak dinners cost more than they did a year ago. Or that stock prices for JetBlue Airways and The Cheesecake Factory surged over 150% from their lows in the spring of 2020.3

Do such price increases signal a coming wave of broad and persistent inflation or just a temporary snapback following the unusually sharp economic downturn in 2020? We simply don’t know. But future inflation is just one of many factors that investors take into account. The market’s job is to take positive information, such as exciting new products, substantial sales gains, and dividend increases, and balance it against negative information, like falling profits, wars, and natural disasters, to arrive at a price every day that both buyers and sellers deem fair.

The future is always uncertain. But willingness to bear uncertainty is the key reason investors have the opportunity for profit.

Let us assume for the moment that rising inflation persists into the future. Some investors might want to hedge against higher inflation, while others might see it as a market-timing signal and make changes to their investment portfolios. But for the market timers to do so successfully, they would need a trading rule that directs exactly when and how to revise the portfolio—“I’ll know it when I see it” is not a strategy. A trading rule based on inflation estimates, however, is just a market-timing strategy dressed in different clothes. A successful effort requires two correct predictions: when to revise the portfolio and when to change it back.

It’s not enough to be negative on the outlook for stocks or bonds in the face of disconcerting information regarding inflation (or anything else). Current prices already reflect such concerns. To justify switching a portfolio, one needs to be even more negative than the average investor. And then outsmart the crowd once again when the time appears right to switch back. Rinse and repeat.

The evidence of success in pursuing such timing strategies—by individuals and professionals alike—is conspicuous by its absence.

To illustrate the problem, imagine it’s New Year’s Day 1979. The broad US stock market4 produced a positive return in 1978 but failed to keep pace with inflation for the second year in a row. Your crystal ball informs you that the next two years will see back-to-back double-digit inflation for the first time since World War I.

What would you do? You have painful memories of 1974, when the inflation-adjusted total return for US stocks was –35.05%, among the five worst returns in data going back to 1926.

We suspect many investors would sell stocks in anticipation of significantly lower security prices over the subsequent two years. The result? Most likely a failure to capture above-average returns from both the equity and size dimensions, as shown in Exhibit 1.

​
Exhibit 1 Looking Up
Cumulative return, January 1979–December 1980

Past performance is no guarantee of future results. Indices are not available for direct investment.

​
Some of the recent concern regarding inflation appears linked to substantial increases in government spending and the US debt load. Determining the appropriate level of each is a contentious public policy issue, and we don’t wish to minimize its importance. But the news items in Exhibit 2 suggest these concerns are not new, and the expected consequences of these issues are likely already reflected in current prices.

The future is always uncertain. But as economist Frank Knight observed 100 years ago, willingness to bear uncertainty is the key reason investors have the opportunity for profit.6 Investors will always have something to worry about, and the possibility of unwelcome or unexpected events should be addressed by the portfolio’s initial design rather than by a hasty response to stressful headlines in the future.

​
Exhibit 2 Fears Through the Years

When the prices of goods and services increase over time, consumers can buy fewer of them with every dollar they have saved. This erosion of the real purchasing power of wealth is called inflation. Inflation is an important element of investing. In many cases, the reason for saving today is to support future spending. Therefore, keeping pace with inflation is a crucial goal for many investors. To help understand inflation’s impact on purchasing power, consider the following illustration of the effects of inflation over time. In 1916, nine cents would buy a quart of milk. Fifty years later, nine cents would only buy a small glass of milk. And more than 100 years later, nine cents would only buy about seven tablespoons of milk. How can investors potentially prevent this loss of purchasing power from inflation over time?
​
Exhibit 1: Your Money Today Will Likely Buy Less Tomorrow

INVESTING FOR THE LONG TERM AND OTHER "TIPS"
As the value of a dollar declines over time, investing can help grow wealth and preserve purchasing power. Investors should know that over the long haul stocks have historically outpaced inflation, but there have also been short-term stretches where this has not been the case. For example, during the 17-year period from 1966–1982, the return of the S&P 500 Index was 6.8% before inflation, but after adjusting for inflation it was 0%. Additionally, if we look at the period from 2000–2009, the so-called “lost decade,” the return of the S&P 500 Index dropped from –0.9% before inflation to –3.4% after inflation.
​
Despite some periods where stocks have failed to outpace inflation, one dollar invested in the S&P 500 Index in 1926, after accounting for inflation, would have grown to more than $500 of purchasing power at the end of 2017 and would have significantly outpaced inflation over the long run. The story for US Treasury bills (T-bills), however, is quite different. In many periods, T-bills were unable to keep pace with inflation, and an investor would have experienced an erosion of purchasing power. After adjusting for inflation, one dollar invested in T-bills in 1926 would have grown to only $1.51 at the end of 2017.

​Exhibit 2: Growth of $1
1926–2017

​While stocks are more volatile than T-bills, they have also been more likely to outpace inflation over long periods. The lesson here is that volatility is not the only type of risk that should concern investors. Ultimately, many investors may need to have some of their allocation in growth investments that outpace inflation to maintain their standard of living and grow their wealth.

One additional tool available to investors who are concerned about both stock market volatility and inflation are Treasury Inflation-Protected Securities (TIPS). TIPS are guaranteed by the US Treasury and as such are considered by the marketplace to have low risk of default. The Treasury issues TIPS with a variety of maturities, and these securities are easily bought and sold. Unlike traditional Treasury securities such as T-bills, TIPS are indexed to inflation to protect investors from an erosion in purchasing power. As inflation (measured by the consumer price index) rises, so does the par value of TIPS, while the interest rate remains fixed. This means that if inflation unexpectedly rises, the purchasing power of any principal invested in TIPS should also increase.1 Although they may not offer the long-term growth opportunities that stocks do, their structure makes TIPS an effective risk management tool for investors who are concerned with managing uncertainty around future purchasing power.

CONCLUSION
Inflation is an important consideration for many long-term investors. By combining the right mix of growth and risk management assets, investors may be able to blunt the effects of inflation and grow their wealth over time. Remember, however, that inflation is only one consideration among many that investors must contend with when building a portfolio for the future. The right mix of assets for any investor will depend upon that investor’s unique goals and needs.

As companies grow to become some of the largest firms trading on the US stock market, the returns that push them there can be impressive. But not long after joining the Top 10 largest by market cap, these stocks, on average, lagged the market.


Ave Annualized Outperformance of Companies Before and After the First Year They Became One of the 10 Largest in the US
Compared to Fama/French Total US Market Research Index,1927–2020

​You only live once! Social media investors have banded together on unconventional platforms to drive up the prices of a handful of “meme stocks,” seemingly without traditional evaluation of investing risks and rewards. They made headlines with their “short squeeze” of GameStop (GME), and, as they garner media attention, their tactics continue. While it’s not the intended victim of the YOLO traders, will the efficient market hypothesis be a casualty of these events? The answer depends a lot on your definition of efficient markets. Perhaps long-term investors would be better served questioning the potential impact on their investment philosophy.

Fama (1970) defines the efficient market hypothesis (EMH) to be the simple statement that prices reflect all available information. The rub is that it doesn’t say how investors should use this information. EMH is silent on the “correct” ways investors should use information and prices should be set. To be testable, EMH needs a companion model: a hypothesis for how markets and investors should behave. This leaves a lot of room for interpretation. Should asset prices be set by rational investors whose only concerns are systematic risk1 and expected returns? It seems implausible to link recent meme-stock price movements to economic risks. Rather, they seem fueled by investor demand to be part of a social movement, hopes to strike it rich with a lucky stock pick, or plain old schadenfreude.

There is a vast ecosystem of investors, from individuals investing in their own accounts to governments and corporations who invest on behalf of thousands. Ask investors why they invest the way they do, and you’ll likely get a range of goals and approaches just as diverse. It’s this complex system that generates the demand for stocks. Another complex system fuels the supply of stocks. Supply and demand meet at the market price. People may contend that the market is not always efficient, or rational, but the stock market is always in equilibrium. Every trade has two sides, with a seller for every buyer and a profit for every loss.

There are plenty of well-studied examples that show supply and demand at work. The huge increase in demand for stocks added to a well-tracked index often creates a run-up in the stock price. Some of this price increase can be temporary and reversed once the tremendous liquidity demands at index reconstitution2 are met. Index reconstitution is just one example; instances of liquidity-driven price movements happen all the time. It is well documented that liquidity demands can produce temporary price movements.3 Investors may wonder if temporary price dislocations motivated by users of r/WallStreetBets differ from those caused by changes to an index. Lots of buying puts temporary upward pressure on prices, which later fall back to “fundamental value”–it sounds familiar. The more relevant observation may be that markets are complex systems well adapted to facilitate the supply and demand of numerous market participants.

There are numerous reasons people may be willing to hold different stocks at different expected returns. Can all those differences be explained by risks? Doubtful. To quote Professor Fama, “The point is not that markets are efficient. They’re not. It’s just a model.”4  EMH can be a very useful model to inform how investors should behave. We believe investing as if markets are efficient is a good philosophy for building long-term wealth. Trying to outguess markets might be a quick way to destroy wealth.

It’s true, you only live once. The good news is that investors can look to market prices, not internet fads, to pursue higher expected returns. Theoretical and empirical research indicate higher expected returns come from lower relative prices and higher future cash flows to investors. Long-run investors can be better served by using markets, rather than chatrooms, for information on expected returns.

The year 2020 proved to be one of the most tumultuous in modern history, marked by a number of developments that were historically unprecedented. But the year also demonstrated the resilience of people, institutions, and financial markets.

The novel coronavirus was already in the news early in the year, and concerns grew as more countries began reporting their first cases of COVID-19. Infections multiplied around the world through February, and by early March, when the outbreak was labeled a pandemic, it was clear that the crisis would affect nearly every area of our lives. The spring would see a spike in cases and a global economic contraction as people stayed closer to home, and another surge of infections would come during the summer. Governments and central banks worked to cushion the blow, providing financial support for individuals and businesses and adjusting lending rates.

On top of the health crisis, there was widespread civil unrest over the summer in the US tied to policing and racial justice. In August, Americans increasingly focused on the US presidential race in this unusual year. Politicians, supporters, and voting officials wrestled with the challenges of a campaign that at times was conducted virtually and with an election in the fall that would include a heightened level of mail-in and early voting. In the end, the results of the election would be disputed well into December. As autumn turned to winter, 2020 would end with both troubling and hopeful news: yet another spike in COVID-19 cases, along with the first deliveries of vaccines in the US and elsewhere.

For investors, the year was characterized by sharp swings for stocks. March saw a 33.79% drop in the S&P 500 Index1 as the pandemic worsened. This was followed by a rally in April, and stocks reached their previous highs by August. Ultimately, despite a sequence of epic events and continued concerns over the pandemic, global stock market returns in 2020 were above their historical norm. The US market finished the year in record territory and with an 18.40% annual return for the S&P 500 Index. Non-US developed markets, as measured by the MSCI World ex USA Index,2 returned 7.59%. Emerging markets, as measured by the MSCI Emerging Markets Index, returned 18.31% for the year.


Exhibit 1: Highs and Lows
MSCI All Country World Index with selected headlines from 2020

Fixed income markets mirrored the extremity of equity behavior, with nearly unprecedented dispersion in returns during the first half of 2020. For example, in the first quarter, US corporate bonds underperformed US Treasuries by more than 11%, the most negative quarterly return difference in data going back a half century. But they soon swapped places: the second quarter was the second-most positive one on record for corporates over Treasuries, with a 7.74% advantage.3 Large return deviations were also observed between US and non-US fixed income as well as between inflation-protected and nominal bonds.

Global yield curves finished the year generally lower than at the start. US Treasury yields, for example, fell across the board, with drops of more than 1% on the short and intermediate portions of the curve.4 The US Treasury curve ended relatively flat in the short-term segment but upwardly sloped from the intermediate- to long-term segment. For 2020, the Bloomberg Barclays Global Aggregate Bond Index5 returned 5.58%.


Exhibit 2: Sharp Shifts
US Credit minus US Treasury: Quarterly Returns, March 1973– December 2020

Uncertainty remains about the pandemic and the broad impact of the new vaccines, continued lockdowns, and social distancing. But the events of 2020 provided investors with many lessons, affirming that following a disciplined and broadly diversified investment approach is a reliable way to pursue long-term investment goals.

MARKET PRICES QUICKLY REFLECT NEW INFORMATION ABOUT THE FUTURE
The fluctuating markets in the spring and summer were also a lesson in how markets incorporate new information and changes in expectations. From its peak on February 19, 2020, the S&P 500 Index fell 33.79% in less than five weeks as the news headlines suggested more extreme outcomes from the pandemic. But the recovery would be swift as well. Market participants were watching for news that would provide insights into the pandemic and the economy, such as daily infection and mortality rates, effective therapeutic treatments, and the potential for vaccine development. As more information became available, the S&P 500 Index jumped 17.57% from its March 23 low in just three trading sessions, one of the fastest snapbacks on record. This period highlighted the vital role of data in setting market expectations and underscored how quickly prices adjust to new information.

One major theme of the year was the perceived disconnect between markets and the economy. How could the equity markets recover and reach new highs when the economic news remained so bleak? The market’s behavior suggests investors were looking past the short-term impact of the pandemic to assess the expected rebound of business activity and an eventual return to more-normal conditions. Seen through that lens, the rebound in share prices reflected a market that is always looking ahead, incorporating both current news and expectations of the future into stock prices.

OWNING THE WINNERS AND LOSERS
The 2020 economy and market also underscored the importance of staying broadly diversified across companies and industries. The downturn in stocks impacted some segments of the market more than others in ways that were consistent with the impact of the COVID-19 pandemic on certain types of businesses or industries. For example, airline, hospitality, and retail industries tended to suffer disproportionately with people around the world staying at home, whereas companies in communications, online shopping, and technology emerged as relative winners during the crisis. However, predicting at the beginning of 2020 exactly how this might play out would likely have proved challenging.

In the end, the economic turmoil inflicted great hardship on some firms while creating economic and social conditions that provided growth opportunities for other companies. In any market, there will be winners and losers-and investors have historically been well served by owning a broad range of companies rather than trying to pick winners and losers.

STICKING WITH YOUR PLAN
Many news reports rightly emphasized the unprecedented nature of the health crisis, the emergency financial actions, and other extraordinary events during 2020. The year saw many “firsts”—and subsequent years will doubtless usher in many more. Yet 2020’s outcomes remind us that a consistent investment approach is a reliable path regardless of the market events we encounter. Investors who made moves by reacting to the moment may have missed opportunities. In March, spooked investors fled the stock and bond markets, as money-market funds experienced net flows for the month totaling $684 billion. Then, over the six-month period from April 1 to September 30, global equities and fixed income returned 29.54% and 3.16%, respectively. A move to cash in March may have been a costly decision for anxious investors.

Exhibit 3: Cash Concerns in 2020

It was important for investors to avoid reacting to the dispersion in performance between asset classes, too, lest they miss out on turnarounds from early in the year to later. For example, small cap stocks on the whole fared better in the second half of the year than the first. The stark difference in performance between the first and second quarters across bond classes also drives home this point.

A WELCOME TURN OF THE CALENDAR
Moving into 2021, many questions remain about the pandemic, new vaccines, business activity, changes in how people work and socialize, and the direction of global markets. Yet 2020’s economic and market tumult demonstrated that markets continue to function and that people can adapt to difficult circumstances. The year’s positive equity and fixed income returns remind that, with a solid investment approach and a commitment to staying the course, investors can focus on building long-term wealth, even in challenging times.

Many investors view dividend payouts as a reliable source of income. However, those expecting to receive consistent dividend income may have been surprised to see lower- than-expected dividend payouts following the onset of the coronavirus pandemic, when both market volatility and market declines were extraordinary. In reality, recent and historical data show that changes in dividend policy are common, especially during times of higher uncertainty.

Aggregate dividend payouts fell meaningfully in the first three quarters of 2020 compared to the same period in 2019. Exhibit 1 shows the dividends earned from a hypothetical $1 million investment in US, developed ex US, and emerging markets in both periods. Developed ex US markets showed the most drastic change with a 41% decrease. Dividend payments in emerging markets decreased by 29% and in US markets by 22%.

Exhibit 1 Drop Zone
Dividends from a Hypothetical $1 Million Investment

Globally, large firms have historically had the highest propensity to offer dividend payouts,1 but even successful, established firms were not immune to the economic consequences of a global pandemic. A few examples help illustrate this point. Harley Davidson (HOG) has been paying dividends to shareholders since the 1990s. In April 2020, the motorcycle manufacturer slashed its dividend from $0.38 per share to just $0.02, a 95% decrease.2 Gap Inc. (GPS) suspended its dividend payments until at least April 20213 after the economic downturn left the clothing brand with particularly poor revenues.

Harley Davidson and Gap were not the only firms to change their dividend policies. As shown in Exhibit 2, 38% of firms in global markets (2,584 companies) that were expected to pay dividends, consistent with their payout history, instead decreased, omitted, or eliminated their dividend payments in the second quarter, more than doubling the 1,248 firms that made similar changes to their dividend policy in the first quarter of the year. The trend continued into the third quarter: 2,699 firms made such changes.

Exhibit 2 Changing Tune
Dividend Policy Changes in Global Markets (% of Dividend- Paying Firms), 2020

A top-heavy stock market with the largest 10 stocks accounting for over 20% of market capitalization and a marquee technology firm perched at No. 1? This sounds like a description of the current US stock market, dominated by Apple and the other FAANG stocks,1 but it is actually a reference to 1967, when IBM represented a larger portion of the market than Apple at the end of 2019 (5.8% vs. 4.1%).

As we see in Exhibit 1, it is not particularly unusual for the market to be concentrated in a handful of stocks. The combined market capitalization weight of the 10 largest stocks, just over 20% at the end of last year, has been higher in the past.

​Exhibit 1 Same Old Story 
Weight of largest stocks by market capitalization in US stock market, 1927–2019

Do you find it puzzling when a bleak economic report emerges from the press, only to be accompanied by a positive surge in the stock market? You’re not alone. The last few weeks have produced many examples of a stark contrast between stock market performance and economic indicators. So why the apparent disconnect?

Markets are forward-looking, meaning current asset prices reflect market participants’ aggregate expectations. Those expectations include whatever future economic developments are anticipated and their potential impact on cash flows, which are key to a stock’s value. For example, if the market expects the economic environment to weaken company cash flows, stock markets may react well in advance of when we observe the impact on cash flows, as expectations are embedded in prices. And the eventual direction of the stock market will depend on how the economic outcome compares to expectations. If things aren’t as bad as expected, poor economic news can be greeted with a positive stock reaction.

Looking Ahead
We can see this anticipatory nature of markets in action by looking at the relation between US gross domestic product (GDP) growth and equity premiums, or stock market returns in excess of one-month US Treasury bills. When annual US equity premiums are plotted against GDP growth for the same year (top panel of Exhibit 1), there is no discernable relation between the two. Changes in GDP have not been strongly related to simultaneous stock market returns.

It’s important to note that this result does not imply financial markets ignore macroeconomic data. After all, GDP encompasses several measures of the economy, not just corporate profits. However, while GDP may be an imprecise representation of the activities that ultimately drive stock prices, further analysis shows that is not the sole cause for the lack of relation between GDP growth and simultaneous equity premiums.

Plotting GDP growth against the previous year’s equity premium (bottom panel of Exhibit 1) reveals a noticeable relation. The positive trend in the data suggests market prices have in fact reacted to changes in GDP but have done so in advance of these economic developments coming to fruition. This result is consistent with markets pricing in their expectation of economic growth.


Exhibit 1 - Plot Development
US equity premium vs. GDP growth, 1930-2019

​That brings us to the latest news headline worrying some investors: the eventual fallout from increasingly large US government expenditures designed to ease the economic burden of the COVID-19 pandemic. Will these efforts ultimately create a financial burden for the US government that affects future stock returns?

The results in Exhibit 2 should help allay concerns over the debt level impacting equity market performance. When we sort countries each year on their debt-to-GDP for the prior year (top panel), average annual equity premiums have been slightly higher for high-debt countries than low-debt countries in both developed and emerging markets. However, the return differences’ small t-statistics—a measure of the precision of a value’s estimate – suggest these averages are not reliably different from one another.1

The top panel uses prior year debt-to-GDP data to sort countries into the high/low groups. But investors may be more focused on where they expect the debt to end up, rather than on where it’s been. In the bottom panel of Exhibit 2, we rank countries on debt-to-GDP at the end of the current year, assuming perfect foresight of end-of-year debt levels. Again, average equity premiums have been similar for high- and low-debt countries. Like the results for GDP growth, these results imply that markets have generally priced in expectations for future government debt.


Exhibit 2 - Debt Defying
Average equity premiums for countries sorted on debt

​MARKETS AT WORK
Macroeconomic variables and investment decisions are like frozen turkeys and deep fryers—caution should be exercised when combining the two. The results presented here are consistent with markets aggregating and processing vast sets of macroeconomic indicators and expectations for those indicators. By incorporating this information into market prices, we believe public capital markets effectively become the best available leading macroeconomic indicator.
​

With activity in many industries sharply curtailed in an effort to reduce the chances of spreading the coronavirus, some economists say a recession is inevitable, if one hasn’t already begun.1 From a markets perspective, we have already experienced a drop in stocks, as prices have likely incorporated the growing chance of recession. Investors may be tempted to abandon equities and go to cash because of perceptions of recessions and their impact. But across the two years that follow a recession’s onset, equities have a history of positive performance.
​
Data covering the past century’s 15 US recessions show that investors tended to be rewarded for sticking with stocks. Exhibit 1 shows that in 11 of the 15 instances, or 73% of the time, returns on stocks were positive two years after a recession began. The annualized market return for the two years following a recession’s start averaged 7.8%.

​Downturns, Then Upturns
Growth of wealth for the Fama/French Total US Market Research Index

​Recessions understandably trigger worries over how markets might perform. But history can be a comfort for investors wondering whether now may be the time to move out of stocks.

Over the past few weeks we've witnessed the global market reaction to uncertainty surrounding the coronavirus. The environment remains fluid with strongly positive and negative movements based on the latest developments. The situation can be unsettling both on a human level and from the perspective of how markets respond. The question is, what historical evidence do we have to provide rational guidance during times like these?

At WealthShape, it is a fundamental principle that markets are designed to handle uncertainty, processing information in real-time as it becomes available. We see this happening when markets decline sharply, as they have recently, as well as when they rise. Such declines can be distressing to any investor, but they are also a demonstration that the market is functioning as we would expect.

Market declines can occur when investors are forced to reassess expectations for the future. The expansion of the outbreak is causing worry among governments, companies, and individuals about the impact on the global economy. Apple announced earlier this month that it expected revenue to take a hit from problems making and selling products in China1. Australia’s prime minister has said the virus will likely become a global pandemic2, and other officials there warned of a serious blow to the country’s economy3. Airlines are preparing for the toll it will take on travel4. And these are just a few examples of how the impact of the coronavirus is being assessed.

Growth of $1 During Outbreaks
S&P 500 Composite Index

We plot the growth of $1 for the S&P 500® Composite Index in the months following the first reported cases of several outbreaks throughout history and show the ending value when the outbreak subsided. There is much uncertainty associated in determining the measurement periods and precise length of each outbreak. It’s impossible to disentangle the market effects of the outbreak itself from other economic forces. The sell-off across stock markets in recent days was attributed to fears surrounding the impact of the coronavirus but happens to coincide with valuation ratios on the high side relative to historical averages for equities. 

The market is clearly responding to new information as it becomes known, but the market is pricing in unknowns, too. As risk increases during a time of heightened uncertainty, so do the returns investors demand for bearing that risk, which pushes prices lower.

We can’t tell you when things will turn or by how much, but our expectation is that bearing today’s risk will be compensated with positive expected returns. That’s been a lesson of past health crises, such as the Ebola and swine-flu outbreaks earlier this century, and of market disruptions, such as the global financial crisis of 2008–2009. Additionally, history has shown no reliable way to identify a market peak or bottom. These beliefs argue against making market moves based on fear or speculation, even as difficult and traumatic events transpire.

The Market’s Response to Crisis
Performance of a Balanced Strategy: 60% Stocks, 40% Bonds
Cumulative Total Return

This shows the performance of a balanced investment strategy following a few historical crises. Each crisis is labeled with the month and year that it occurred or peaked. The subsequent one-, three-, and five-year annualized returns start from the first day of the month following each crisis. Although a global investment strategy would have suffered losses immediately following most of these events, the financial markets recovered over time, as indicated by the positive five-year cumulative returns. Negative events such as these may tempt investors to flee the financial markets. But diversification and a long-term perspective can help investors apply discipline to ride out the storm.

Conclusion
In the mind of some investors, there is always a “crisis of the day” or potential major event looming that could mean the beginning of the next drop in markets. As we know, predicting future events correctly, or how the market will react to future events, is a difficult exercise. It is important to understand, however, that market volatility is a part of investing. To enjoy the benefit of higher potential returns, investors must be willing to accept increased uncertainty. A key part of a good long-term investment experience is being able to stay with your investment philosophy, even during tough times.

Financial planning combined with a well‑thought‑out, transparent investment approach can help people be better prepared to face uncertainty and improve their ability to stick with their plan and ultimately capture the long-term returns of capital markets. Amid the anxiety that accompanies developments surrounding the coronavirus, decades of financial science and long-term investing principles remain a strong guide.

Investors often see dividends as a way to generate income. But dividend strategies are not the only way to produce cash, and investors should be aware of the potential tradeoffs that accompany a focus on dividends.
​
For stockholders who own dividend-paying shares, those payments arrive on a schedule (quarterly, in many cases). The cash to fund a dividend must come from somewhere, however. We know the price of a stock is potentially influenced by all expected future cash flows to shareholders. If cash is paid today in the form of a dividend, the stock price—and total market capitalization—of the issuing company may therefore fall, as the hypothetical Portfolio A in Exhibit 1 shows. That means, all else being equal, an investor who receives a dividend may also be left with a less valuable equity holding.
​
Exhibit 1: Pay, Your Way
Comparing methods of income generation

Cash Considerations
An alternative method of raising cash is to simply sell shares. Exhibit 1 compares the two methods of generating income by contrasting Portfolio A with the similarly valued hypothetical Portfolio B. While Portfolio A receives income through a dividend payout, Portfolio B generates it through a stock sale.
The investor in Portfolio A, in which a dividend is issued, ends up holding the same number of shares as were held prior to the dividend payout, but we assume that those shares have declined in value. The investor in Portfolio B holds a reduced number of shares that haven’t seen their value decrease as a result of a dividend payout. The two approaches arrive at the same place—both investors end up with $100 in cash and $1,900 in stock, notwithstanding potential trading costs or tax implications. But there are potential downsides to the dividend approach when contrasted with the stock-sale approach.
​
First, the average proportion of firms paying dividends in the US was about 52% from 1963 through 2019, meaning an investor focusing only on those stocks is missing out on nearly half of investible US companies. A second consideration is that a dividend’s value, while not subject to the same degree of fluctuation as a stock price, isn’t guaranteed. Just 10 years ago, more than half of dividend-paying firms cut or eliminated those payouts following the financial crisis. More recently, a company that had consistently paid dividends for more than a century, General Electric, slashed its payout to just one cent a share, and the UK’s Vodafone Group cut its full‑year dividend for the first time in two decades. Thirdly, investors may give up flexibility in terms of the timing and the size of the payout when they rely on company-issued dividends. With stock sales, an investor determines the amount and schedule of the income.

Total Return
When considering an investment, it is also important to assess total return, which accounts for capital appreciation (or loss) alongside dividend income. High dividend yields may not lead to high total returns. Exhibit 2 plots the trailing 12-month returns of S&P 500 Index constituents as of December 31, 2019, with each dot representing a company. It’s clear that companies with greater dividend yields, the dots located higher up the vertical axis, weren’t consistently those with a higher total return over that period.

Exhibit 2: Income Facts
Dividend yields and 12-month returns for S&P 500 firms as of December 31, 2019

​Income generation may be a priority for some investors, but other important investment considerations, such as diversification and flexibility, needn’t fall victim to that aim. While the use of stock sales instead of dividends to create cash flow may involve trading costs and tax considerations, those concerns may be offset by the benefits of investing in companies that don’t currently pay dividends. An approach focused on income derived through dividends may not be the most desirable choice when weighing broader investment goals.

Imagine it is early January 2010 and you are reading a review of the financial markets. Investors have been on a roller coaster over the past three years, living through the stress of the global financial crisis and market downturn of 2008–2009, then experiencing the recovery that began in March 2009 and is still going strong.

Investors who rode out the market’s slide are beginning to be rewarded. But the rebound is 10 months old, and markets have a long way to go to reach their previous highs. Opinions are mixed about what might unfold in the coming year. A December 2009 headline in the Wall Street Journal underscored the uncertainty: “Bull Market Shows Signs of Aging.”1 The publication pointed out that, although stocks have rallied and indices are on the rise, worries are mounting in some quarters that the market is running out of steam.

From the vantage point of early 2010, you may be wondering whether to stick with your investment plan or move into cash and wait for more evidence that the markets have recovered. Now, fast forward to today and consider what the global equity markets delivered to investors who stayed the course.

On a total return basis, global stocks more than doubled in value from 2010–2019, as Exhibit 1 shows. The MSCI All Country World IMI Index, which includes large and small cap stocks in developed and emerging markets, had a 10-year annualized return of 8.91%. From a growth-of-wealth standpoint, $10,000 invested in the stocks in the index at the beginning of 2010 would have grown to $23,473 by year-end 2019.

Exhibit 1: Growth of Wealth
MSCI All Country World IMI Index, January 2010–December 2019 

Despite positive annual market returns during most of the decade, investors had to process ever-present uncertainty arising from a host of events, including an unprecedented US credit rating downgrade, sovereign debt problems in Europe, negative interest rates, flattening yield curves, the Brexit vote, the 2016 US presidential election, recessions in Europe and Japan, slowing growth in China, trade wars, and geopolitical turmoil in the Middle East, to name a few.

The decade also brought technological advances in electronic commerce and cloud computing, the global embrace of the smartphone and social media, increased automation and enhanced artificial intelligence, and new products like electric cars and early iterations of self-driving ones.

Looking back, you could conclude that the decade had its share of uncertainty—just like the decades before. But overall, the US equity market experienced moderate volatility compared with previous decades. Exhibit 2 displays this by looking at returns and standard deviation, where a higher standard deviation reflects wider market swings during that decade.

BENEFITS OF DIVERSIFICATION
Exhibit 2: Volatility in Perspective
S&P 500 Index annualized returns grouped by decade (1930–2019) 

Investors who committed to global diversification and to areas of the market associated with higher returns—small cap stocks and value stocks (i.e., stocks trading at low relative prices)—were challenged over the past decade. As shown in Exhibit 3, during the 2000s, investors were generally rewarded for holding emerging markets stocks and developed ex US stocks. During the 2010s, the US market outperformed developed ex US and emerging markets.

​The performance of value stocks vs. growth stocks (i.e., stocks trading at high relative prices), and small vs. large cap stocks, also varied between decades.

Exhibit 3: The Past Two Decades—2000s vs. 2010s
Annualized returns (%)

Small cap and value stocks outperformed large cap and growth stocks in the 2000s, while the 2010s produced mixed outcomes. Small caps underperformed large caps in the US and emerging markets but outperformed in the developed ex US market. Value underperformed growth in all three market regions. Despite underperforming large cap and growth in the US, small cap and value delivered 11.83% and 11.71%, respectively, for the decade.

Exhibit 4 shows the cumulative investment experience over both decades, with small cap and value stocks outperforming large cap and growth stocks, respectively, across the US, developed ex US, and emerging markets. The annualized 20-year returns illustrate how diversification can help investors ride out the extremes to pursue a positive longer-term outcome.

Over the past decade, global fixed income also posted returns that may have surprised some investors. In 2010, investors looking at historically low interest rates may have expected rising rates as financial markets and economies recovered from the crisis. But over the decade, short-term rates increased while long-term rates decreased. Realized term premiums were positive, as long-term bonds generally outperformed shorter-term bonds. Realized credit premiums were also positive, as lower-quality bonds generally outperformed higher-quality bonds.2

ENDURING PRINCIPLES
That brings us to now—January 2020. Stocks and bonds in the US, and in many other developed markets and emerging markets, logged strong returns last year. The US bull market is 10 years old, and current headlines can give investors other reasons to worry about the future—for example, a pushback on globalization, the effects of climate change, the limits of monetary policy, the fate of Brexit, and the vagaries of the 2020 US presidential race. And those are merely the known unknowns. Looking ahead, who can say what the next 10 years will bring? The only certainty is the decade will have its own set of surprises.

Here’s what we can learn from the past decade (and the ones that came before it): Despite all the change and uncertainty, the fundamentals of successful investing endured. Diversify across markets and asset groups to manage risks and pursue higher expected returns. Stay disciplined and maintain a long-term perspective. Take the daily news with a grain of salt and avoid reactive investment decisions based on fear or anxiety. Don’t try to predict future performance or time the markets. Instead, develop a sensible investment plan based on a strong philosophy—and stick with it.
​
Investors who follow these principles can have a better financial journey in any decade.

The year 2019 served up many examples of the unpredictability of markets.

Interest rates that US policy makers expected to rise fell instead. American consumers’ confidence weakened as the year began, and news headlines broadcast fears of an economic slowdown. But investors who moved onto the sidelines may have missed the gains in the US stock market. As of the end of October, the S&P 500 was up more than 20% for the year on a total-return basis. That puts it on course for the best showing since 2013 should that gain hold through December.

The Greek stock market swung from a 37% decline last year to a 37% advance this year.

Outside the US, Greece—the site of an economic crisis so dire some expected the country to abandon the euro earlier this decade, and a country whose equity market lost more than a third of its value last year—has had one of the most robust stock market performances among emerging economies in 2019. On top of that, Greece issued bonds at a negative nominal yield, which means investors paid for the privilege of lending the government cash.

Taken as a whole, it’s a reminder that the prediction game can be a losing one for investors.

Exhibit 1: Shifting Curves
Yields on US Treasuries of various maturities since the end of 2018

UP OR DOWN?
A closer look at interest rates and the bond market shows just how unpredictable asset performance can be. Going into 2019, Federal Reserve officials expected economic conditions to support raising a key interest rate benchmark twice. Instead, policy makers lowered it three times.

In the market for US Treasuries—where market participants set interest rates—the yield curve that tracks Treasuries inverted for the first time in more than 10 years, as seen in Exhibit 1. Some long-term yields fell below some short-term yields over the summer. What’s more, yields on medium- and long-term bonds were at historically low levels at the start of the year, but they fell even lower by the end of October. Investors who made moves based on the expectation yields would rise in 2019 may have been disappointed in how events ultimately transpired.

​Exhibit 2: Changes in the Ranks
Performance of equity markets in 23 developed and 24 emerging economies

TRADING PLACES
Events weren’t any easier to anticipate in the global equity markets, where no evident link appears between markets that performed well last year and those that have excelled this year, as Exhibit 2 shows.

Among the 23 developed market countries, only one country was a Top 5 performer for 2018 and 2019: the US. Last year’s strongest performing market— Finland—ranked 22nd this year through the end of October. Among emerging markets, Greece swung from a 37% decline last year to a 37% advance this year through the end of October.

PERENNIAL WISDOM
History has shown there’s no compelling or dependable way to forecast stock and bond movements, and 2019 was a case in point. Neither the mainstream prognostications nor the hindsight of recent strong performance predicted outcomes in 2019.
​
Rather than basing investment decisions on predictions of which way debt or equity markets are headed, a wiser strategy may be to hold a range of investments that focus on systematic and robust drivers of potential returns. Investors who were broadly diversified across asset classes and around the globe were in a position to potentially enjoy the returns that the markets delivered thus far in 2019. Last year, this year, next year—that approach is a timeless one.

The stocks commonly referred to by the FAANG moniker— Facebook, Amazon, Apple, Netflix, and Google (now trading as Alphabet)—have posted impressive gains through the years, with all now worth many times their initial-public-offering prices. The notion of FAANG stocks as a powerful group holding sway over the markets has sunk its teeth into some investors. But how much of the market’s recent returns are attributable to FAANG stocks? And does their performance point to a change in the markets?

Exhibit 1: A Little Help from the FAANGs
Annualized US market compound returns with and without Facebook, Amazon, Apple, Netflix, and Alphabet (Google), 2009–2018

Over the 10 years through December 31, 2018, the US broad market returned an annualized 13.4%, as shown in Exhibit 1. Excluding FAANG stocks, the market returned 12.6%. The 0.8-percentage-point bump resulted from the FAANGs collectively averaging a 30.4% yearly return over the decade.
​
Investors may be surprised to learn that it is actually common for a subset of stocks to drive a sizable portion of the overall market return. Exhibit 2 shows that excluding the top 10% of performers each year from 1994 to 2018 would have reduced global market performance from 7.2% to 2.9%. Further excluding the best 25% of performers would have turned a positive return into a relatively large negative return.

This lesson also applies to capturing the premiums associated with a company’s size and its price-to-book ratio. Research by Eugene Fama and Kenneth French (”Migration,” 2006) provides evidence that these premiums are driven in large part by a subset of stocks migrating across the market.

Exhibit 2: Weighing the Impact
Global stock market performance excluding top performers, 1994–2018

​Research has shown no reliable way to predict the top-performing stocks. Looking at the top 10% of stocks by performance each year since 1994, on average less than a fifth of that group has ranked in the top 10% the following year.

The tendency for strong market performance to be concentrated in a subset of stocks is therefore also a cautionary tale about the importance of diversification— investors with concentrated portfolios may actually miss out on the very stocks that deliver the best of what the market has to offer. An investment approach built around broad diversification can help achieve a more reliable outcome for investors over the long term—sharp acronym or not.
​

The first decade of the 21st century, and the second one that’s drawing to a close, have reinforced for investors some timeless market lessons: Returns can vary sharply from one period to another. Holding a broadly diversified portfolio can help smooth out the swings. And focusing on known drivers of higher expected returns can increase the potential for long‐term success. Having a sound strategy built on those principles - and sticking to it through good times and bad - can be a rewarding investment approach.
​
“THE LOST DECADE”?
Looking at a broad measure of the US stock market, such as the S&P 500, over the past 20 years, you could be forgiven for thinking of Charles Dickens: It was the best of times and the worst of times (see Exhibit 1). For US large cap stocks, the worst came first. The “lost decade” from January 2000 through December 2009 resulted in disappointing returns for many who were invested in the securities in the S&P 500. An index that had averaged more than 10% annualized returns before 2000 instead delivered less‐than‐average returns from the start of the decade to the end. Annualized returns for the S&P 500 during that market period were −0.95%. ​

Yet it was a good decade for investors who diversified their holdings globally beyond US large cap stocks and included other parts of the market with higher expected returns—companies with small market capitalizations or low relative price (value stocks). As Exhibit 2 shows, a range of indices across many other parts of the global market outperformed the S&P 500 during that time span.

​FLIPPING THE SCRIPT
The next period of nine‐plus years reveals quite a different story. It has looked more like best of times for the S&P 500, as the index, when viewed by total return, has more than tripled since the start of the decade in the bounce‐back from the global financial crisis. US large cap growth stocks have been some of the brightest stars during this span. Accordingly, from 2010 through the first half of 2019, many parts of the market that performed well during the previous decade haven’t been able to outperform the S&P 500, as Exhibit 3 displays. Since many of these asset classes haven’t kept pace with the S&P, these returns might cause some to question their allocation to the asset classes that drove positive returns during the 2000s. ​

THE CASE FOR GREAT EXPECTATIONS
It’s been stated many times that investors may want to take a long‐term perspective toward investing, and the performance of stock markets since 2000 supports this point of view. Over the past 19 1⁄2 years (see Exhibit 4), investing outside the US presented investors with opportunities to capture annualized returns that surpassed the S&P 500’s 5.65%, despite periods of underperformance, including the most recent nine‐plus years. Cumulative performance from 2000 through June 2019 also reflects the benefits of having a diversified portfolio that targets areas of the market with higher expected returns, such as small and value stocks. And it underscores the principle that longer time frames increase the likelihood of having a good investment experience.

​No one knows what the next 10 months will bring, much less the next 10 years. But maintaining patience and discipline, through the bad times and the good, puts investors in position to increase the likelihood of long‐term success. 

Further complicating matters, for investors to have a shot at successfully timing the market, they must make the call to buy or sell stocks correctly not just once, but twice. Professor Robert Merton, a Nobel laureate, said it well in a recent interview with Dimensional: 

“Timing markets is the dream of everybody. Suppose I could verify that I’m a .700 hitter in calling market turns. That’s pretty good; you’d hire me right away. But to be a good market timer, you’ve got to do it twice. What if the chances of me getting it right were independent each time? They’re not. But if they were, that’s 0.7 times 0.7. That’s less than 50-50. So, market timing is horribly difficult to do.” 

Exhibit 1: Average Annualized Returns After New Market Highs
S&P 500, January 1926–December 2018 ​

​“I knew the market was going to crash.” It’s a common investment expression that you’ve likely heard plenty of times. However, is there any reason to take such statements seriously? Hindsight bias has been deceiving investors for years. Once we’ve had time to digest information, it can often seem like yesterday’s news should have been more predictable. Perhaps the best way to avoid behavioral hazards is to first acknowledge that they exist. Recognizing what we really know versus what’s unknowable may be the single most important investment decision we ever make.

The history of stock markets is filled with ups and downs which after the fact appear to be easily identified. The huge leverage risk-taking by banking/investment and insurance firms leading up to the 2008 financial crisis is blatantly visible today. We’ve had the benefit of 10 years to reflect. Nobel prize-winning psychologist, Daniel Kahneman would say, it’s during this time of careful observation that hindsight creates an illusion of understanding. Essentially our brains screw up the timeline. Signs of danger appear more obvious after the fact than they were in real time.  

In 2008, a variety of dominoes had to fall on the way to peak awareness. When it became evident that the housing market was bolstered by bad loans with roots extending across the financial spectrum, markets reacted exactly as they should. They priced in the new information and the results were painful.

Investing in 20/20 hindsight can lead to an even more detrimental exercise in creating a misconception that future events are coming based on information that is wholly unknowable. This is evidenced by an unending flow of soothsaying from financial media outlets. A few examples:

​One Day later: October 21st 1987

​​One of the single best days in market history was October 21, 1987, only two days after the Black Monday market crash. The S&P 500 was up 9.10%
​

So much time and energy focuses on things that are unknowable in the moment. News by definition is unpredictable. Therefore, any action taken as an investor must answer the following: “What are the chances that I know something that everyone else doesn’t? Furthermore, even if I do know something, how long will I be the only one? And finally, what are the chances that my information has already been incorporated into current market values?”
 
Today we carry more computing power in our pockets than all of NASA did when it put the first men on the moon in 1969. Needless to say, news travels at an incredible speed. By the time it reaches you and me, it’s almost a certainty that markets have already incorporated the latest news into prices. This simple fact demonstrates the value or lack thereof for opinions based on past events. Investors should remain conscious of the brain’s tendency to value “known information” as if it were “unknown.” By doing so, we can better combat the impacts of hindsight decision making.

What’s an investor to do?
It’s folly to suggest in retrospect that market prices were wrong because they were never perfect in the first place. Their primary role is to provide the best representation of all available information at the moment. It’s a far better exercise to follow the preponderance of evidence we know exists. Markets tend to be resilient to crisis over the long term and investors have historically been rewarded for maintaining behavioral discipline. Therefore, an accurate forecast of future events isn't a prerequisite for success.
​
​
The Market’s Response to Crisis
Performance of a Balanced Strategy: 60% Stocks, 40% Bonds (Cumulative Total Return)

Over the last several years, index funds have received increased attention from investors and the financial media.

Some have even made claims that the increased usage of index funds may be distorting market prices. For many, this argument hinges on the premise that indexing reduces the efficacy of price discovery. If index funds are becoming increasingly popular and investors are “blindly” buying an index’s underlying holdings, sufficient price discovery may not be happening in the market. But should the rise of index funds be a cause of concern for investors? Using data and reasoning, we can examine this assertion and help investors understand that markets continue to work, and investors can still rely on market prices despite the increased prevalence of indexing.

Many buyers and sellers
While the popularity of indexing has been increasing over time, index fund investors still make up a relatively small percentage of overall investors. For example, data from the Investment Company Institute shows that as of December 2017, 35% of total net assets in US mutual funds and ETFs were held by index funds, compared to 15% in December of 2007. Nevertheless, the majority of total fund assets (65%) were still managed by active mutual funds in 2017. As a percentage of total market value, index-based mutual funds and ETFs also remain relatively small. As shown in Exhibit 1, domestic index mutual funds and ETFs comprised only 13% of total US stock market capitalization in 2017.

Exhibit 1.    Investor Breakdown in the US Stock Market as a Percentage of Total US Stock Market Capitalization

​In this context, it should also be noted that many investors use nominally passive vehicles, such as ETFs, to engage in traditionally active trading. For example, while both a value index ETF and growth index ETF may be classified as index investments, investors may actively trade between these funds based on short-term expectations, needs, circumstances, or for other reasons. In fact, several index ETFs regularly rank among the most actively traded securities in the market.

Beyond mutual funds, there are many other participants in financial markets, including individual security buyers and sellers, such as actively managed pension funds, hedge funds, and insurance companies, just to name a few. Security prices reflect the viewpoints of all these investors, not just the population of mutual funds.

As Professors Eugene Fama and Kenneth French point out in their blog post titled “Q&A: What if Everybody Indexed?”, the impact of an increase in indexed assets also depends to some extent on which market participants switch to indexing: “If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.”
 
What’s the volume?
Trade volume data are another place to look for evidence of well-functioning markets. Exhibit 2 shows that despite the increased prevalence of index funds, annual equity market trading volumes have remained at similar levels over the past 10 years. This indicates that markets continue to facilitate price discovery at a large scale.

Exhibit 2.      Annual Global Equity Market Trading Volume, 2007–2018

​Besides secondary market trading, there are also other paths to price discovery through which new information can get incorporated into market prices. For example, companies themselves can impact prices by issuing stock and repurchasing shares. In 2018 alone, there were 1,633 initial public offerings, 3,492 seasoned equity offerings, and 4,148 buybacks around the world.3 The derivatives markets also help incorporate new information into market prices as the prices of those financial instruments are linked to the prices of underlying equities and bonds. On an average day in 2018, market participants traded over 1.5 million options contracts and $225 billion worth of equity futures.

Hypothesis in practice
Even though the historical empirical evidence suggests that the rise of indexing is unlikely to distort market prices, let’s consider the counterargument that the rise of indexing does distort markets and in turn causes prices to become less reliable. In this scenario, wouldn’t one expect stock-picking managers attempting to capture mispricing to have an increased rate of success over time?

Exhibit 3 shows little evidence that this has been the case. This chart shows the percentage of active managers that survive and beat their benchmarks over rolling three-year periods. These data show that there is no strong evidence of a link between the percentage of equity mutual fund assets in index funds and the percentage of active funds outperforming benchmark indices.

​Exhibit 3.      Active Manager Performance Has Not Improved
Percentage of Non-Index Equity Funds Outperforming for Three-Year Rolling Period, 2004–2018

Lastly, in a world where index funds bias prices, we should expect to see evidence of such an impact across an index fund’s holdings. In other words, there should be more uniformity in the returns for securities within the same index as inflows drive prices up uniformly (and outflows drive prices down). Taking the S&P 500 Index as an example, however, we see that this has not been the case. The S&P 500 is a widely tracked index with over $9.9 trillion USD indexed or benchmarked to the index and with indexed assets comprising approximately $3.4 trillion USD of this total. Exhibit 4 shows that in 2008, a year of large net outflows and an index return of –37.0%, the constituent returns ranged from 39% to –97%. This exhibit also shows that in 2017, a year of large net inflows and a positive index return of 21.8%, the constituent returns ranged from 133.7% to –50.3%. We would also expect that constituents with similar weighting in traditional market cap-weighted indices would have similar returns. In 2017, Amazon and General Electric returned 56.0% and –42.9%, respectively, despite each accounting for approximately 1.5% of the S&P 500 Index.

Exhibit 4.     Range of S&P 500 Index Constituent Returns

​Conclusion
Despite the increased popularity of index-based approaches, the data continue to support the idea that markets are working. Annual trading volume continues to be in line with prior years, indicating that market participant transactions are still driving price discovery. The majority of active mutual fund managers continue to underperform, suggesting that the rise of indexing has not made it easier to outguess market prices. Prices and returns of individual holdings within indices are not moving in lockstep with asset flows into index funds. Lastly, while naysayers will likely continue to point to indexing as a hidden danger in the market, it is important that investors keep in mind that index funds are still a small percentage of the diverse array of investor types. Investors can take comfort in knowing that markets are still functioning; willing buyers and sellers continue to meet and agree upon prices at which they desire to transact. It is also important to remember that while indexing has been a great financial innovation for many, it is only one solution in a large universe of different investment options.

A quick online search for “Dow rallies 500 points” yields a cascade of news stories with similar titles, as does a similar search for “Dow drops 500 points.” These types of headlines may make little sense to some investors, given that a “point” for the Dow and what it means to an individual’s portfolio may be unclear. The potential for misunderstanding also exists among even experienced market participants, given that index levels have risen over time and potential emotional anchors such as a 500-point move do not have the same impact on performance as they used to. With this in mind, we examine what a point move in the Dow means and the impact it may have on an investment portfolio.

IMPACT OF INDEX CONSTRUCTION
The Dow Jones Industrial Average was first calculated in 1896 and currently consists of 30 large cap US stocks. The Dow is a price-weighted index, which is different than more common market capitalization-weighted indices.1

An example may help put this difference in weighting methodology in perspective. Consider two companies that have a total market capitalization of $1,000. Company A has 1,000 shares outstanding that trade at $1 each, and Company B has 100 shares outstanding that trade at $10 each. In a market capitalization-weighted index, both companies would have the same weight since their total market caps are the same. However, in a price-weighted index, Company B would have a larger weight due to its higher stock price. This means that changes in Company B’s stock would be more impactful to a price-weighted index than they would be to a market cap-weighted index.

The relative advantages and disadvantages of these methodologies are interesting topics themselves, but the main purpose of discussing the differences in this context is to point out that design choices can have an impact on index performance. Investors should be aware of this impact when comparing their own portfolios’ performance to that of an index.

HEADLINES VS. REALITY
Movements in the Dow are often communicated in units known as points, which signify the change in the index level. Investors should be cautious when interpreting headlines that reference point movements, as a move of, say, 500 points in either direction is less meaningful now than in the past largely because the overall index level is higher today than it was many years ago.
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Exhibit 1 plots what a decline of this magnitude has meant in percentage terms over time. A 500-point drop in January 1985, when the Dow was near 1,300, equated to a nearly 39% loss. A 500-point drop in December 2003, when the Dow was near 10,000, meant a much smaller 5% decline in value. And a 500-point drop in early December 2018, when the Dow hovered near 25,000, resulted in a 2% loss.

HOW DOES THE DOW RELATE TO YOUR PORTFOLIO?
While the Dow and other indices are frequently interpreted as indicators of broader stock market performance, the stocks composing these indices may not be representative of an investor’s total portfolio. For context, the MSCI All Country World Investable Market Index (MSCI ACWI IMI) covers just over 8,700 large, mid, and small cap stocks in 23 developed and 24 emerging markets countries with a combined market cap of more than $50 trillion. The S&P 500 Index includes 505 large cap US stocks with approximately $23.8 trillion in combined market cap.2 The Dow is a collection of 30 large cap US stocks with a combined market cap of approximately $6.8 trillion.3

Even though the MSCI ACWI IMI, S&P 500, and Dow are all stock market indices, each one tracks different segments of the market, so their performance can differ significantly over time, as shown in Exhibit 2. Since 1995, the Dow has outperformed the S&P 500 and MSCI ACWI IMI by an average of 0.5% and 3.3%, respectively (based on calendar year returns). However, relative performance in individual years can be much different. For example, in 1997, the Dow underperformed the S&P 500 by 8.4% but outperformed the MSCI ACWI IMI by 13.9%.
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It is also important to note that some investors may be concerned about other asset classes besides stocks. Depending on investor needs, a diversified portfolio may include a mix of global stocks, bonds, commodities, and any number of other assets not represented in a stock index. A portfolio’s performance should always be evaluated within the context of an investor’s specific goals. Understanding how a personal portfolio compares to broadly published indices like the Dow can give investors context about how headlines apply to their own situation.

CONCLUSION
News headlines are often written to grab attention. A headline publicizing a 500-point move in the Dow may trigger an emotional response and, depending on the direction, sound either exciting or ominous enough to warrant reading the article. However, after digging further, we can see that the insights such headlines offer may be limited, especially if investors hold portfolios designed and managed daily to meet their individual goals, needs, and preferences in a broadly diversified and cost-effective manner.
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