For some, Memorial Day weekend marks the unofficial beginning to the summer vacation season. With the average cost of gas expected to be the lowest it has been since 2004.1 it follows that the number of drivers on the road for the start of the summer driving season will be on the rise. And with the increase of drivers comes the inevitable traffic jams. No matter what your destination is, I think one thing everyone has in common is a universal contempt for being stuck in traffic. And of course, while stuck in traffic, there is the added frustration of the “do I switch lanes or stay in the same lane” dilemma. A type of dilemma that is not unknown to investors.
Watching drivers in other lanes whiz by while you are stuck in the slow lane is not a great feeling. Stop me if this hasn’t happened to you. After waiting long enough, you get this itch to switch into the other lane because you can actually see it moving faster and you justify that there is no reason it shouldn’t continue doing so. But then, you convince yourself that maybe your lane will pick up again. You go back and forth until finally deciding to switch to the fast lane and then, boom, dead stop. The lane you were in finally starts moving and you can’t get back over. That’s what chasing returns in the market can feel like.
Let’s apply this example to an investing principle that investors have been struggling with in recent years – diversification. In our investing example, we specifically look at the returns of global equities over the last 15 years. Consider the following three equity asset categories:
- U.S. large caps – measured by the S&P 500 index
- Developed international – measured by the MSCI EAFE index
- Emerging markets – measured by the MSCI EM index
If we look at the most recent five-year period from 2011 to 2015 we have the following annualized returns:2
- U.S. large caps – 12.6 %
- Developed international – 4.1%
- Emerging markets – -4.5%
It seems to be a no-brainer that U.S. large caps are the right place to put our money and with the threat of slowing global growth, the U.S. seems to be a safer option. But what if we looked at the annualized returns from 2005 to 2010, a time period that includes the great recession2?
- U.S. large caps – 2.3%
- Developed international – 2.9%
- Emerging markets – 13.1%
Now it would seem that the tables have turned and even through one of the most volatile markets in recent history, the best performing asset class of the three shown was emerging markets.
How can an investor hope to capture the best of these returns? The answer we come back to time and time again is diversification. Looking back over the past 15 years, the chart below shows how each asset class performed relative to one another. Could you imagine trying to weave your way through these lanes?
If you had chosen the fastest lanes each year, you would have had an annualized return of 17.5 percent. Choose the slowest lanes each year however, and you would have lost 4.0 percent of your capital.2 That’s a huge variance and a challenge that can be difficult to overcome when wrangling with normal investor emotions. In a simple diversified equity model,4 the ride is a bit smoother and the average expected return comes in at 5.2 percent.2
If you’re tired of guessing which lane will move you towards retirement, then it’s time to talk to Fragasso.
1 Short-term energy and summer fuels outlook
2 Annualized return calculations based on data pulled from Morningstar
3 Morningstar data
4 Diversified equity model in this example consists of: 50% – S&P 500, 40% – MSCI EAFE, 10% – MSCI EM.
5 Tips to Help You Set and Achieve Your Financial Goals