WE CAN’T CONTROL the financial markets. But we can pretty much guarantee we’ll pocket whatever the stock and bond markets deliver—by buying index funds. So why do I hear so much grousing from indexers?
At issue isn’t a failure of index funds, but rather a failure of investors’ expectations. Over the past few months, I’ve heard from countless hardcore indexers who have done the sensible thing and built globally diversified portfolios. Often, they own some variation of the classic three-fund portfolio: a total U.S. stock market index fund, a total international stock index fund and a broad U.S. bond market fund. Yet they have a gnawing sense of unease—because their portfolio hasn’t kept up with the U.S. stock market averages.
As stocks have soared while interest rates have bumped along at miserably low levels, many investors have written to me, questioning the need to own bonds. More recently—and, to me, more troubling—the disdain has extended to foreign stock markets.
This, of course, smacks of performance chasing. Over the past five years, the S&P 500 has clocked 13.1% a year, while MSCI’s Europe, Australasia and Far East index has eked out a 5.9% annual gain and the Bloomberg Barclays Aggregate Bond index has managed just 2.3% a year. The past few weeks will, no doubt, further fuel investors’ discontent. Foreign stocks have taken it on the chin, their prices knocked down by turmoil in Turkey and a strengthening U.S. dollar. The latter cuts the value of foreign shares for U.S. holders.
What we’re seeing, however, is more than just performance chasing. From the comments I’ve received, there’s a pervasive belief that U.S. stocks are both safer and offer higher returns, and that foreign stocks are both riskier and destined to underperform. I’ve heard from folks who complain about sketchy accounting and weaker property rights abroad, which suggest foreign stocks are a dodgier proposition. In the next sentence, they’ll tell me that international markets have always underperformed and will always underperform. They then go on to say that they can get all the foreign exposure they need with U.S. multinationals, which they happily acknowledge perform just like U.S. stocks.
Got all that? Maybe it’s time to revisit first principles—and recall both the reasons we diversify and the unbreakable connection between risk and reward.
When we spread our investment bets widely, we’re looking for both short- and long-term portfolio protection. In the short-term, owning thousands of securities from different parts of the global market will give us a less volatile portfolio, as some securities zig when others zag. Meanwhile, over the long haul, global diversification increases the odds that we’ll meet our financial goals, because there’s less risk our portfolio’s performance will be badly derailed if one or two parts of the financial markets post truly wretched returns.
We won’t get this short- and long-term protection if our sole investment is U.S. stocks, including U.S. multinationals. Nothing is going to zig when our U.S. stocks zag, so we lose the short-term portfolio protection. What about the long haul? We’ll be sunk if the next decade sees U.S. stocks sink.
That brings me to the contention that U.S. stocks are both safer and sure to outperform over the long term. I find this bizarre. Remember, these comments are coming from folks who have drunk the Kool-Aid, accepted that markets are efficient and banked their life’s savings on index funds.
If we accept that markets are efficient, we’re buying into the notion that all parts of the financial markets have similar risk-adjusted expected returns. True, those expectations almost certainly won’t be met: Some market segments will do surprisingly well, while others will disappoint.
Nonetheless, our starting assumption should be that risk and expected return are joined at the hip. We shouldn’t start with the idea that one market—the U.S. stock market, in this case—is not only safer, but also pretty much guaranteed to deliver superior returns. If that were the case, rational investors everywhere would buy U.S. stocks, driving up their price and eliminating this free lunch.
This raises an obvious question: Are U.S. stocks in a bubble? I am loath to even mention the word. I feel we’re too quick to slap the “bubble” label on any asset that’s recently performed well. Much of the time, bubbles are only apparent later, when we look back and marvel at the magnitude of the comeuppance and clearly see the folly that preceded it.
But bubble or not, many U.S. investors—including many indexers—are displaying an alarming degree of home bias. U.S. stocks may offer comforting familiarity. But they’re also more expensive than other major markets, and they alone don’t make a good portfolio.
I believe every investor should look at his or her investment mix and ask, “What if I’m wrong?” What if U.S. shares are priced so richly that a decade of terrible performance lies ahead? I’m not predicting it will happen, but I can’t be sure it won’t—and I don’t want the consequences of that potentially terrible performance to nix my retirement. That’s why I have roughly a third of my portfolio in U.S. stocks, a third in foreign stocks and a third in bonds. I won’t end up with the greatest returns. But I’m pretty confident I won’t end up broke.
STARTING WITH THIS ISSUE, I’m increasing the frequency of this newsletter to twice a month. A big reason: Email subscribers have been asking that I regularly put out a list of new blog posts. Your wish is granted: Below, you’ll find links to the articles that have been published since the last newsletter.
Keep in mind that HumbleDollar’s homepage doesn’t just include five or six new blogs each week. There’s also a slew of other features, including intriguing statistics, action items, daily insights, an archive feature and highlighted sections from our comprehensive money guide. If you want to see these other features, make a point of checking out the homepage on a regular basis.
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