Eat Well. Sleep Well.
The Federal Reserve has lowered yields so far that stocks are more appealing.
Given their higher risk, stocks should be expected to outperform U.S. Treasury bonds over a long period. In this video, we explain why we now have even more confidence than usual that stocks will do better.
Here is a PDF version with speaker notes.
The opinions expressed here represent our thinking at the time of publication and may change without notice. We are not obligated to update this website.
Rex discusses how the pandemic has impacted our clients; implications of the election; parallels between betting on sports and investing; and mistakes investors make. The interview is just under 5 minutes. Thanks to 680thefan.com for the air time.
Recently, the “fiduciary rule” has been in the news. As the home page on our website says “We hold ourselves out as professionals and fiduciaries meaning that it is our legal and ethical duty to put your interests ahead of our own.” We hope that is clear to you.
What’s clear to us is that a lot of investors have more trust in their advisors than is warranted. Brokers and advisors are not always required to put their clients’ interests first. There have been unsuccessful efforts to change this. As reported by CNBC:
The 5th Circuit Court of Appeals ruled on March 15 that the Labor Department overstepped its authority by creating the so-called fiduciary rule, parts of which went into effect last year. In general, the rule requires advisors and brokers to put their clients’ interests before their own when advising on retirement accounts such as 401(k) plans and individual retirement accounts.
Advisors and brokers do not have to put their clients’ interests first. In our opinion this can lead to higher fees and less appropriate investments.
What is home country bias? How can it hurt your investment performance? How do you recognize it? How can you neutralize it?
At the time of this writing, we expect higher returns from non-US stocks than U.S. stocks. We are writing this out of concern that home country bias may hurt investors’ performance. We stop short of saying that investors shouldn’t be biased; rather, we believe investors should be conscious of home country bias and comfortable with its effects if they are going to be biased.
What is home country bias (HCB)? It’s the tendency for investors to prefer investments in their domestic market. For example, U.S. investors tend to prefer U.S. investments.
How prevalent is HCB? According to a study by Vanguard, U.S. investors have about 80% of their equity investments in the U.S. despite the fact that U.S. equities are only about 50% of the global equity market. This is also true globally: Australians allocate 66% of their investments to their home country versus a global market weight of 2%; in Japan it is 55% versus 7%; in the U.K.it is 26% versus 7%.
Why might a HCB hurt you? When U.S. stocks underperform markets in other countries, over-weighting U.S. stocks will detract from your performance. That’s pretty obvious. Some will also argue that global diversification is less risky than concentrating on your home market. That may be, but the advantage is small given that the U.S. market has historically tended to exhibit less volatility than foreign markets. Of course, HCB helps your portfolio when the U.S. market is outperforming.
Here are the ten year return expectations from Research Affiliates as of July 31, 2017:
|
Market |
Expected Return |
| U.S. Large (S&P 500) | 2.6% |
| International Developed | 6.9% |
| Emerging (a.k.a. Developing) | 8.7% |
International developed includes countries such as Germany, France, Japan and the U.K. Emerging includes China, Russia and Brazil. Source: Research Affiliates
A global stock investor holding 50% US, 40% international developed, and 10% emerging (which is close to the global market value weights) would have a 5.3% expected return as compared to an investment in the S&P 500 with a 2.6% expected annual return. If the investor has 60% of their portfolio in equities, they would expect an additional 1.6% annually. This increased return would add about 15% to an investor’s portfolio (before taxes and inflation) over the 10 years due to compounding.
Why a HCB might be right for you? Even if the absolute return and risk is expected to be lower, you may still choose to tilt toward the U.S. for a variety of reasons. Doing so may make you feel better or safer or satisfy patriotic wishes. While you may not actually be safer with your bias, you may feel that way just as people may feel safer in a car than a plane.
How to tell if you have a home country bias? If you compare your performance to the S&P 500 or Dow indices without consideration of international stocks, you clearly have a bias. Technically and mathematically speaking, you have a bias if your weight to U.S. stocks exceeds the weighting of U.S. stocks in the global market.
Why only discuss the bias related to equities and not fixed income? In our case, we use fixed income mainly to control risk. Investing in U.S. bonds avoids currency risk. Additionally, many of our clients are taxable and municipal bonds offer tax advantages that foreign bonds do not. We will consider non-US fixed income in portfolios, but generally these are substitutes, at least to an extent, for equities.
What should an investor do? Our recommendation is to consciously select a benchmark that reflects your preferences. If your preference is for the best investment performance and you permit global investments, then your equity benchmark should be a global stock index such as the MSCI All Country World Index (ACWI). At this time, the exchange traded fund based on this index (the ticker is ACWI) has a weighting to the US of about 50%. If you are uncomfortable with this weight, then you can select a blend of indices that represents the U.S. (e.g., the S&P 500 or our preference the Russell 3000) and an index of non-U.S. stocks (e.g. ACWIxUS). For example, one might choose an allocation of 75% to the Russell 3000 and 25% to the ACWIxUS. After establishing a benchmark, one can then tilt their portfolio according to one’s expectations about the markets.
You have two investment options. You can invest in cash which returns 0% each day, and you can invest in a stock which on any given day has a 50% random chance of losing one-half of its value and a 50% chance of doubling. How should you allocate your money between the two? To be clear, over time if you buy and hold the stock, you expect a zero growth because ½* 2 = 1
It may seem that there is no way to make money, but that wouldn’t make for an interesting post. In fact, you could expect to make about 6% per day on average if you could trade without transaction costs.
Put ½ your money in cash and ½ in the stock and rebalance to that proportion every day. You would expect that on half of the days the stock will go down and your portfolio will be worth 0.75 of its previous value. This is because you would have the half that you put in cash plus one-half of the half you put into stocks. On the days the stock goes up, your portfolio will be worth 1.5x as much because you will have the half you invested in cash plus 2x the half you put in stocks.
Thus, every two days we’d expect the portfolio to grow by a factor of 0.75 * 1.5 = ¾ * 3/2 = 9/8. Over n days, the growth factor would be (9/8)^(n/2).
Thus if you started with $1, you’d expect to have $361 over 100 days.
Even if both your investment choices are lousy, there still might be a way to make money. Imagine your investment choices are stocks A and B. On any given day there is a 50% random chance that A will only be worth 10 cents on the dollar – it loses 90% of its value. There is a 50% chance it will double. Thus over time, we’d expect to lose money if we only held that stock. In fact, after two days, we’d expect to have twenty cents on the dollar. That doesn’t sound good. Stock B is exactly the same except when A loses 90%, B will double and when A doubles, B loses 90%. So now we have 2 lousy individual investments (but the good news is they move out of synch). Let’s split our money between the two and see what happens.
Each day our portfolio will grow by a factor of (0.5 * 0.1) + (0.5 * 2) = 1.05. Yes, even though both stocks on average lose money each day, we would make 5% each and every day.
In the absence of transaction costs, one can make money on volatility just by rebalancing. You can even make more than the best performing investment. The tough question is why aren’t we all rich?
While this is not investment advice and is for entertainment / educational purposes, it does suggest the benefit of diversifying and rebalancing.
If you are fascinated by this and you like math, you may want to read the paper “Universal Portfolios” by Thomas Cover.