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Benchmarks, Divergency and Volatility Impact

 

One of the most surprising facts about the DJIA is that, though it’s often considered a benchmark for the entire US Stock Market, the index contains only 30 companies.  It’s just a sliver of the entire global stock market.  The S&P 500, as you may already know, contains 500 companies so it’s a bit bigger than the DJIA.  But both the S&P 500 and the DJIA are poor benchmarks for a diversified portfolio of stocks because those two indices focus solely on large U.S. companies.  Neither comes close to representing the performance of the 19,000 publicly traded stocks in the U.S. (4,000 companies on the NYSE and NASDAQ…plus an additional 15,000 stocks traded over the counter).  

Nor do these two indices represent stocks trading outside the U.S.   Approximately 75% of the world’s publicly traded companies are now found outside the U.S.  Both the DJIA and the S&P 500 are just a fraction of the total global stock market which you may be surprised to find out contains more than 100,000 publicly traded stocks. 

Measuring stock market performance based on the movements of the Dow Jones Industrial Average (DJIA) or S&P 500 is analogous to measuring the performance of an entire super market based on how well the meat department is doing. 


Clearly the Dow and S&P 500 do not represent “the market" if we define the market as all publicly traded companies available to investors.   Some say that those indices should still be considered bellwethers because the biggest and best companies are in the US.  But that’s not entirely true either.  The U.S. does have a disproportionate share of the largest companies in the world but of the largest 2,000 companies in the world, 693 reside in the U.S. and the remaining 1,307 are foreign companies.

Below is an illustration that shows the geographically diversity of the the global equity markets.  The largest 2,000 public companies span 55 countries, with two-thirds residing outside of the U.S…..though more than half of the companies can be found in just three countries - the U.S., Japan and the U.K. 

 



If you’re beginning to think the DJIA and S&P 500 are terrible comparisons for a global multi-asset class portfolio of stocks, you’re right! 

The fact of the matter is that the global equity markets are just too large and diverse to measure with one index.  Over short periods of time we see incredible divergence among the stock markets of various countries.  And within those countries we see more divergence between stocks of large companies and small companies as well as value stocks and growth stocks. 

Let’s take a look at a few recent multi-year periods where global equity asset class returns differed by significant amounts.  We’re currently in one of those periods of great divergence as evidenced by Figure 1 below.  Figure 1 shows the performance of five major global equity asset classes. 

SPY  (blue)     = US Large Company Stocks                                                    
IJR  (red)        = US Small Company Stocks                                                      
EFA  (green)  = International Developed Markets Stocks                  
EEM  (pink)    = International Emerging Markets Stocks                      
ICF  (purple)   = Real Estate Investment Trusts (REITs)     
                   
 
Figure 1: Major Global Equity Asset Class Performance – Past Two Years
December 15, 2013 to December 15, 2015

Since mid-December 2013, REITs and US Large Company Stocks (like the S&P 500) have greatly outperformed both US Small Company stocks and International stocks.  Any investor holding a diversified basket of global equities might be disappointed if they mistakenly believed the S&P 500 (SPY) was their benchmark. 

However, I'm sure this same investor was delighted during the two-year period following the U.S. technology bubble, when the performance of large U.S. companies as measured by the S&P 500 was dead last among major equity asset classes.  It's no coincidence that during this period the very same asset classes that have suffered recently did spectacularly well back then.  

Figure 2: Major Equity Asset Class Performance – Post Technology Bubble
January 1, 2003 to December 31, 2005


Lastly, let’s look at the 2-year period following the financial crisis of 2008.  Again, the S&P 500 lagged behind all but one of the major global equity asset classes as illustrated in Figure 3 below.

Figure 3: Major Equity Asset Class Performance – Post Financial Crisis
January 1, 2009 to December 31, 2010


Why is this an important and timely topic?  Because over the span of 24 years of successful investing, I’ve seen too many investors abandon a sound strategy because during some short-term period they feel their strategy is “underperforming.”  They feel this way during periods like the recent two-year period because they are mistakenly comparing their portfolios to the wrong benchmarks. 

It’s important for the long-term investor, who believes as I do that the future movements of markets are largely unpredictable, to understand that by investing in the global equity markets you ensure that your portfolio will never perform the same as the S&P 500 or the DJIA because you simply own more than one thin slice of the global equity pie.   But that’s a good thing!  The S&P 500 is more volatile than a diversified portfolio of global stocks.  By owning different markets and companies around the globe, both small and large, you ensure that you’ll never have all of your money in the best performing asset class but also ensure you won’t have it all in the worst performing asset class.  And that’s the goal of asset class investing: to smooth out the ride and achieve stock market returns with less volatility risk.   

Why is less volatility so important?  Because lowering volatility increases return.  Let’s take a look at the example below.



As shown in the illustration above, lower volatility can result in a higher compound return and greater terminal wealth.  Although Portfolio 1 experiences a strong gain in the first year, this gain is more than eliminated in year two.  Portfolio 2 experiences a much smaller gain and loss during the two-year period, but the lower volatility of returns produces a higher compound return and preserves more portfolio value.  Managing volatility is particularly crucial during a market downturn.  After experiencing a loss, a portfolio must earn an even higher return in future periods to fully recover to its previous level.

To lower volatility we invest in different asset classes that are moving in the same upward direction over time but doing so in very dissimilar patterns.  This is the very definition of diversification!  To be successful asset class investors, we must not let the media provide us with flawed benchmarks in which to compare our performance.  The S&P 500 is only a fair benchmark for US Large Company stocks.  It's a poor comparison for a multi-asset class globally diversified portfolio. 

If you believe there are exciting long-term growth opportunities all around the globe and thus have your money spread among thousands of large and small companies within dozens of countries, then there will be periods in which you outperform the S&P 500 and years in which you lag behind…but our exposure to small company stocks, value stocks and international stocks should lower our short-term volatility thus enhancing our long-term returns.   

Thanks for reading!