Looking Back to Look Ahead: Reflections on the Markets & Investing (Part II)

At the end of the year, it is always an interesting exercise to take a look back at the investment landscape and the lessons to be gleaned from the behavior of markets and participants.

If you missed Part I on the behavior of bonds in 2014 and the impact of a well-diversified investment approach, please click here.


What’s diversification done for me lately?

The Periodic Table of Investment Returns, which may be familiar to many of you, does a good job of depicting the difficulty in discerning patterns of asset class performance from year to year.

Periodic Table of Investment Returns

A wealth of interesting market information is contained within this simple display, which ranks the returns of each asset class (represented by color-coded indices) annually from top to bottom. A primary takeaway is the unpredictability of asset class returns from year to year. An asset class that is at the top one year may be at the bottom the next. There is no consistent pattern.

The last column in the chart shows 2014 returns through the end of November. It points to another interesting aspect of the recent market environment — U.S. stocks and bonds are at the top of the rankings. An “old-school” strategy of investing exclusively in U.S. large-cap stocks and investment-grade bonds has outperformed a more diversified global approach by a wide margin. As an example, a narrow domestic benchmark of 60% S&P 500/40% Barclays Capital Aggregate returned 13.3% for the year ended September 30, beating 94% of the plans in the Callan Associates’ plan sponsor universe (which can be seen as representing the broad group of institutional investors), where the median return was 10.0%.1

Diversified portfolios were certainly hurt over this period by their small-cap exposure. Mega-cap stocks have been the place to be. While smaller company stocks have higher expected returns over time, they trailed large-cap stocks by almost 16% for the year ended September 30.

Back to the future

This isn’t the first time that diversified portfolios have underperformed the S&P 500 by a good margin. Some of us recall the mid-to-late 90s, when U.S. large-cap stocks — especially growth stocks — had a multi-year reign. Tech stocks were shooting the lights out, and you were missing out if you had international and small-cap stocks dragging you down. What followed, just as everyone jumped on the bandwagon? The dot-com bubble burst, and the “Lost Decade” for large-cap stocks ensued.

But it wasn’t a lost decade for diversified portfolios. Small-cap stocks moved back to the forefront, beating the S&P 500 for the next six years, usually by wide margins.
Emerging markets had five 25%+ years in a row from 2003-2007. The point is that there are always periods where one asset class does well and is touted as the place to be, the wave of the future, and in fact, does quite well for a while. But you are never told when that is going to end. No alarm bells go off, but the direction shifts.

And the chatter is all about the thing that has done well, and why that should continue. We are hearing a fair amount of that now about U.S. large-cap stocks.

Why not just stick with the U.S.?

Global exposure certainly hasn’t helped lately. International stocks in both developed and emerging countries have taken a hit recently, and in fact, have lagged U.S. stocks for quite some time. For the five years ended November 30, foreign stocks have trailed their U.S. counterparts by more than 10% annually.


After an initially strong market recovery following the crash in 2008, other countries have suffered a series of setbacks against the backdrop of a stronger, albeit still muted, U.S. recovery — the European Debt Crisis, slowing growth in China and other emerging markets, double-dip recessions in Europe and Japan, political crises, a tsunami and currency devaluation vs. a strong dollar. Plummeting oil prices are a recent wild card.

Given the problems overseas and the comparative strength of the U.S. economy and markets, investors may question having international exposure at all. That brings us back to the Periodic Table. International stocks have outperformed the U.S. for long periods (see 2003-2007), strongly outpacing the U.S. in the years leading up to the crash.
We don’t know when the next period might be. With the market’s strong multi-year rally, U.S. stocks are selling at higher valuations than most of the world and its own historical average. Emerging markets, by contrast, are cheaper relative to both the world and their own history.2 The U.S. is ending stimulus efforts as the Eurozone, Japan and China expand theirs.

It’s a wide, wide world

No matter the prospects in any individual country, the U.S. represents about half of the world’s total market capitalization. That’s down from about 68% in 1990. Over that same period, emerging markets have grown from less than 1% to 11% (after topping out above 15%) of the total world.3 While expectations for GDP growth in emerging countries have declined, the World Bank still estimates them to grow at more than twice the rate of the developed world (about 5.5% vs. 2.5%).4

None of this is to say that we expect international stocks to outperform U.S. stocks next year — we’ll leave forecasting to the economists. But, having exposure to them provides important country and currency diversification, and the opportunity to participate in global growth. While placing a bet on the U.S. may have been a winning strategy recently, taking such a narrow approach will likely result in higher volatility and extended periods of underperformance. Plus, you may miss out on some excellent growth opportunities around the world.

To 2015 and beyond

The portfolio represented by the light blue Moderate Benchmark in the Periodic Table, containing broad and global diversification, typically provides a smoother ride and gives investors a better chance of capturing returns wherever they happen to occur.

Maybe next year will be the year when bonds finally get hit or U.S. stocks come back to earth — or maybe not. A broadly diversified portfolio with the right mix of global stocks and bonds positions investors to participate, whatever the outcome.


Past performance is not indicative of future results. Actual investors may experience materially different returns than those of any index or benchmark, and it should not be assumed that future performance will be profitable or will equal the performance of any index or benchmark. Index and benchmark performance is used to provide an approximation of the returns of the applicable asset class. The returns presented reflect the reinvestment of dividends and other earnings, but do not reflect the effect or deduction of taxes, investment advisory fees, custodial fees, transaction fees or other fees, the incurrence of which could materially reduce performance. Index and return information is derived from sources Hewins deems reliable, but has not been independently verified. It is not possible to invest directly in an index, and the volatility of an index may be materially different from that of any fund or portfolio.

The returns for the Moderate Benchmark represent results for broadly diversified index-based asset allocations during the corresponding time period. The Moderate Benchmark is a broadly diversified 60% equity/40% fixed income allocation comprised of indices deemed appropriate for each sub-asset class within the allocation, and is subject to revision at any time. The historical Moderate Benchmark performance results are provided exclusively for comparison purposes. It should not be assumed that any Hewins account holdings will correspond directly to any such comparative allocations. The performance results for the Moderate Benchmark reflect monthly rebalancing. That is, each month, regardless of performance, the allocation to each investment style is adjusted to reflect the model allocation. The results reflect hypothetical, back-tested results of the Moderate Benchmark that were achieved by means of the retroactive application of the allocation, and, as such, the corresponding hypothetical results have inherent limitations, including: (1) the results do not reflect the results of actual trading, but were achieved by means of the retroactive application of the Moderate Benchmark allocations, certain aspects of which may have been designed with the benefit of hindsight; (2) back tested performance may not reflect the impact that any material market or economic factors might have had on the allocation used; and, (3) for various reasons (including the reasons indicated above), any actual investor may have experienced investment results during the corresponding time periods that were materially different from those portrayed for the Moderate Benchmark. Current Moderate Benchmark Components: 28% BC Aggregate Index, 4% BC Global Agg Index ex US, 2% JPM Emer Mkt Bond +, 6% ML High Yield CP BB-B, 13.5% MSCI EAFE Index, 4.5% MSCI Emer Mkt Index, 10.5% Russell 2000, 31.5% S&P 500 Index.

Common Indices:
S&P 500 (Large Cap Equity)
The Standard & Poor’s 500 Stock Index (S&P 500) is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S. The index includes the stocks of 500 leading U.S. publicly traded companies from a broad range of industries.

Russell 2000 (Small Cap Equity)
The Russell 2000 Index is an unmanaged index that measures the performance of the small-cap segment of the U.S. equity universe. It is a subset of the Russell 3000 Index, representing approximately 10% of the total market capitalization of that index and includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. Russell Investment Group owns the Russell Index data, including all applicable trademarks and copyrights.

MSCI EAFE (International Equity, Developed)
The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization-weighted index that is designed to measure the equity market performance of developed markets, excluding the U.S. & Canada. The MSCI
Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom*.

MSCI Emerging Markets (International Equity, Emerging)
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

BC Aggregate (Core Fixed Income)
The Barclays Capital U.S. Aggregate Index provides a broad-based measure of the domestic investment-grade fixed income market. It is an unmanaged index of taxable, investment-grade, U.S. dollar-denominated fixed-income securities of domestic issuers having a maturity greater than one year.

BofA Merrill Lynch U.S. High Yield, BB-B Rated, Constrained (High Yield Fixed Income)
BofA Merrill Lynch U.S. High Yield, BB-B Rated, Constrained Index tracks the performance of US dollar-denominated below-investment-grade (BBB rated) corporate debt publicly issued in the US domestic market. Qualifying bonds are capitalization-weighted provided the total allocation to an individual issuer does not exceed 2%. Issuers that exceed the limit are reduced to 2% and the face value of each of their bonds is adjusted on a pro-rata basis.

BC Global Aggregate ex U.S. (International Fixed Income, Developed)
The Barclays Capital Global Aggregate Bond ex U.S. Index (unhedged) is a subset of the Barclays Capital Global Aggregate Bond Index. It is an unmanaged index considered representative of bonds of foreign countries.

JPM EMBI Global Diversified (Emerging Markets Fixed Income)
The JP Morgan EMBI Global Diversified is a uniquely weighted index that tracks total returns for U.S. dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.
The index limits the weights of countries with larger debt stocks by only including a specified portion of these countries’ eligible current face amounts of debt outstanding.

3 Month T-Bill
3 Month Treasury Bill is a short-term debt obligation backed by the U.S. government with a maturity of 90 days.


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Looking Back to Look Ahead: Reflections on the Markets & Investing (Part II)

time to read: 8 min