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The last few months have been uncertain times for U.S. investors. After years of marching relentlessly higher, U.S. equity market growth has pared to a modest 3-4% since the end of 2014. In spite of the modest recent performance of US equities, many investors feel that many asset classes are “expensive.”Investors have many questions: has the U.S. stock market peaked? When will the central bank begin to increase interest rates? What are the prospects for emerging and developed markets? We will discuss these questions, and their implications, below.More than anything, investors are probably wondering what they should do. We strongly believe that in times like these, investors need to stay the course, with a diversified portfolio that has the risk-appropriate mix of equities and bonds. The markets could be poised for a pullback — or for several more years of growth. Adjusting a portfolio in anticipation of future market movements usually underperforms a long-term strategic allocation held through market cycles.
For the U.S. stock market, mixed signals
Throughout the last several quarters, signs of a sustainable, healthy U.S. economy have been mixed, leaving investors with lots of questions about the future. Unemployment is still trending down, reaching 5.4% in April. However, continued slack (excess capacity) in the labor market has left wages stagnant throughout the recovery, with few signs of future increases. Inflation remains below 2%, and company profits, which had reached all-time highs in 2013, abated slightly in 2014.These signals have led U.S. equities in a mostly sideways trajectory for the last several months, with little clarity promised on the immediate horizon. Though U.S. stock market indices have hit all-time record highs, there aren’t major structural issues in the economy that should derail continued stock market increases.(S&P 500 performance for the 12 months ending May 19, 2015.)
Timing uncertainty over interest rate hikes
Fixed income markets remain high as central banks around the world keep interest rates at historic lows. The Federal Reserve will eventually bump their benchmark lending rate up, pushing bond values down. However, the timing of the rate increase remains uncertain. Though Fed watchers think the central bank will nudge their benchmark rates higher as early as September, the last two quarters produced annualized GDP growth of just 1.2%. Perhaps this tentative performance may lead the Fed to postpone their rate hike.
Continued growth for developed markets
In contrast to the United States, developed markets have performed well over the last six months, as major central banks around the world initiated monetary easing policies and international economies emerged from recession. Debt concerns among many southern European nations (Italy, Spain, and Portugal) receded, though Greece’s fate as part of the Eurozone remains uncertain. Even with global political issues weighing on markets (e.g., Ukraine-Russia border skirmishes and Iranian nuclear negotiations), prospects for continued growth among international economies appears strong.(12-month performance chart of EFA, an index fund tracking the MSCI EAFE Index)
Emerging markets uncertainty
Meanwhile, emerging markets have also bounced back from weaker showing in 2014, with help from an uptick in oil prices and interest rate reductions in China. Nonetheless, future growth is uncertain as global demand for oil and emerging economy exports fluctuates.
(12-month performance chart of EEM, an index fund tracking the MSCI Emerging Markets Index)
The importance of staying the course in a diversified portfolio
When there is uncertainty on the horizon, a balanced, well-diversified portfolio is what investors need, as it enables profit in upward markets and protection against downward movement.It makes good investing sense to avoid tactical market timing, because adjusting a portfolio in anticipation of future market movements usually underperforms a long-term strategic allocation held through market cycles from top to bottom and back. It’s better to hold a risk-appropriate portfolio for the long run than sit on the sidelines hoping to avoid an imminent crash, while the market continues a strong run.As always, it’s important for all investors to confirm regularly that their portfolio allocation matches their risk tolerance, enabling them to ride fluctuations that affect any specific asset class.
How’s your portfolio doing?Sounds like an easy question. It’s not. Because the followup question should be: “Compared to what?”Compared to your coworkers? Probably not the best way to gauge your performance, but a popular one.Compared to the performance you need to reach your retirement goal? A good question, but what if you could reach your goals more quickly by pursuing a different strategy?Compared to a benchmark? Now we’re getting somewhere. But what benchmark should you use?
Commonly used benchmarks
The Dow Jones Industrial Average, every evening newscast’s favorite index, is a peculiar beast: it rounds up 30 extra-large companies, chosen mostly arbitrarily, and then weights them in an outdated fashion to come up with the number we are all familiar with.Few funds or investors actually benchmark their own performance against the Dow. The S&P 500 index, on the other hand, is used as a benchmark all the time. However, the S&P comes in two flavors, and using the wrong one makes it easy to overstate performance.The S&P 500 price index is the one you hear reported in financial news. It does not include dividends. Since everybody considers dividends part of their return, however, and the S&P 500 is currently yielding just under 2% in dividends, they shouldn’t be ignored.The S&P 500 Total Return index (i.e., with dividends reinvested) is actually a good benchmark for certain portfolios—those concentrating on large US companies with a blend of value and growth strategies. So always look for the Total Return, or “TR” label.
What is a good benchmark?
A good benchmark should roughly reflect the holdings of a portfolio (or fund). That includes characteristics like company size, country, and asset class risk. An S&P 500 benchmark, then, is a good comparison tool for large-cap domestic funds — or investors whose portfolios are in large-cap U.S.-based companies. It doesn’t make sense, however, to use the S&P 500 as a benchmark for a multi-asset class diversified portfolio, or if all your assets are in a total U.S. fund. (That is why the Vanguard Total Stock Market ETF (VTI) tracks the performance of the CRSP U.S. Total Market Index, made up of 4,000 companies; or nearly every public company in the U.S.)
What about your portfolio?
We’ve written in the past about some of the hurdles active investors face: high costs, high taxes, and little evidence that any stock-picker or market-timer actually demonstrates skill rather than luck.Here’s another problem with active investing: it’s extremely difficult to tell how you’re doing.It’s not enough to know that your portfolio is up over a given period. That’s great. But the relevant question is: are you up compared to an appropriate passive benchmark? If not, you’re wasting time pursuing an active strategy when you could just buy some ETFs and take more naps.But calculating your portfolio’s performance and choosing an appropriate benchmark are both difficult tasks.To calculate performance, you’ll need to get intimate with Excel (or Google Drive)’s XIRR function, unless all of your holdings are with a broker that calculates your internal rate of return (IRR). Most don’t.Then, once you have your IRR, you need to know what to compare it to. The S&P 500? Probably not, unless your whole portfolio concentrates on large US companies. You need to compare against a portfolio whose equity and bond components are similar to your own. If you specialize in value stocks, for example, compare against a value fund.If you don’t trade stocks yourself but buy and hold actively managed funds, benchmarking is a little easier. Go to Morningstar.com, look up each fund, and read about its holdings (you did this before buying the fund, right?). Then compare to an index fund pursuing a similar strategy.
The easy way out is the right way
What if you’re a passive investor, holding only index funds or ETFs and rebalancing them regularly without trying to time the market?You’re in luck. Index funds are defined by buying up their benchmark index (they’re called index funds, after all!), in the same proportions as the stocks comprising the index. You’re not trying to beat the market; you’re trying to do exactly as well as the market. It might be reassuring to check from time to time, to make sure that your index fund’s trend line is almost precisely equal to its underlying benchmark (minus expenses).Then you can get back to the important calculations: How close am I to retirement? And is it naptime yet?
Note: Direct comparisons between your portfolio’s performance and equity market indices are not without complications. Your portfolio may not be fully invested, may contain options and other derivative securities, may contain fixed income investments, may include short sales of securities and margin trading, and may not be as diversified as market indices. Indices may be unmanaged, may be market weighted, and unlike your portfolio, indices do not incur fees and expenses. Due to the differences between your portfolio and the performance of equity market indices, no such index is directly comparable to your portfolio.
To err is human, but when it comes to investing, mistakes can be costly. A third of everyday investors had zero or negative returns in 2014, according to an analysis of the portfolios of more than a quarter million investors who sync their portfolios with SigFig. In a year that saw the S&P 500 surge by 13.6%, the median investor’s portfolio rose just 4.2%.Ironically, many investors make mistakes because they’re trying to beat the market, and more importantly, because they think they can, says Harold Evensky, chairman of Evensky & Katz wealth management firm and Professor of Practice at Texas Tech University.At speaking engagements or lectures, Evensky often asks his audience to raise hands if they think their children or grandchildren are better than average. Typically, everyone does. “Statistically, that can’t be,” Evensky says. “But it’s classic behavior. People don’t like the idea of being average.”It is in that pursuit of better-than-average performance that investors often fall into one or more traps that may hurt their portfolios in the long run:
1. Single-stock concentration
Six in 10 investors have more than 10% of their portfolios invested in a single stock, according to SigFig data. Moreover, 15% of investors have more than half of their portfolios invested in just two stocks.Many of these investors work (or worked) for a company with a generous employee stock discount program, or one that distributes bonuses in the form of company stock. Alternatively, shares the investor purchased years ago may have appreciated so much that they have thrown their overall asset allocation out of whack. The horror stories of Enron and Washington Mutual employees should provide a sufficient reminder that single stock concentration exposes investors to excessive risk that can jeopardize their financial future.
2. Home Bias
Pride in one’s home country is patriotic, but letting that patriotism undermine one’s investment strategy is ill-advised. Evensky recalls assembling a portfolio for a potential client, who then banged his fist on the desk and stormed out of the office when he saw that a sizeable portion would be invested in international funds. “Forget it,” the client said. “I’ll never invest a penny outside of the United States.”The example may be extreme, but the mistake is common. For 60% of investors in SigFig’s analysis, international equities represented less than 10% of their equity portfolio. At the end 2013, U.S. investors held, on average, 27% of their total equity allocation in international funds, according to Vanguard (citing Morningstar data) — even though non-U.S. equities accounted for 51% of the global stock market. While no one answer fits all, Vanguard recommends “a reasonable starting allocation to non-U.S. stocks of 20%, with an upper limit based on global market capitalization.”
3. Paying more for “better returns”
With 1,411 ETFs available at the end of 2014, according to the Investment Company Institute, investors have plenty of options to choose from to build a well-diversified low-cost portfolio. How low can low-cost go? According to SigFig data, investors paid on average 17 basis points for ETFs, with popular ones like State Street’s SPDR S&P 500 Trust (SPY) and Vanguard’s Total Stock Market Index (VTI) charging 0.09% and 0.05%, respectively.However, six in 10 investors represented in SigFig’s analysis own at least one fund with an expense ratio of 0.50% or higher. “They’re buying a good story,” Evensky explains. An investor who in effect pays a professional to beat the market is doing it because they don’t want to feel that they’re doing average investing. “They buy the Kool Aid. The stories of very smart people using technology and research that’s going to beat the system,” he says.Study after study has shown that more expensive, actively-managed funds do not outperform lower-cost index funds over the long run, even during bear markets. Simply put, paying more doesn’t guarantee better returns. So why do it?
4. Overtrading and/ or timing the market
More than a decade has passed since University of California Davis professors Brad Barber and Terence Odean published their now widely-referenced study with the catchy title, “Trading is Hazardous to Your Wealth.” Its conclusion — that frequent trading is associated with lower returns — holds true today. In a recent analysis, SigFig found that each 100% of portfolio turnover (that is, selling all holdings in one’s portfolio and buying new ones — which one in five investors do, the data shows) corresponds to a 50-basis-point decrease in returns.Even a conservative example shows how much of an impact those extra 50 basis points per year could have over the long term. If you save $10,000 a year for retirement and average a 6% annualized return, that total would grow to $816,044 after 30 years. If we reduce that annualized return by 50 basis points to 5.5%, you would end up with $70,000 less.Would you give up a year’s worth of retirement living expenses (or more) in the pursuit of better-than-average returns? “We try to educate our clients upfront that we’re not always going to beat the market,” says Evensky, whose firm manages $1.5 billion. “Our goal is to be in-between, and if we can do as well [as the market] and minimize taxes and expenses, we’ve done our job right.” It’s a goal worth pursuing, whether you work with a financial advisor, or manage your investments yourself.
Note: A version of this article first appeared in US News & World Report.
Editorial DirectorAleks runs content at SigFig. Before joining the company, she ran the editorial teams at Visually and Mint.com. Her work has appeared on SmartMoney.com and the Wall Street Journal, among others. At lunchtime and on weekends, you'll find her swimming, biking or running -- or all three, in that order.
Data Science and AnalyticsBenny does all things data and science at SigFig. He was Director of Product Analytics at TinyCo and a Principal at Applied Predictive Technologies, where he helped companies run smarter experiments. He studied Economics at Harvard, is an avid cook, and loves running.