“Recency bias” describes our tendency to overemphasize the impact of recent events, which often leads to incorrect or short-sighted conclusions. Our investment philosophy naturally removes recency bias because it is centered around investing for the long term. One of our primary investment principles is designing a globally diversified portfolio. At any given time, however, certain regions, such as the United States, will perform better than others, but forecasting which regions will outperform is difficult. For example, while the US markets have done particularly well post-2008 relative to international markets, they lagged for a full decade previously. Thus, we believe it is optimal to maintain a diversified global portfolio.
The third quarter of 2018 saw low unemployment, climbing inflation, and strong economic growth. As a result, the Federal Reserve continued its interest rate hike trajectory, slowly weaning the economy off monetary stimulus. Risk assets had a strong quarter, with US equity markets returning +7.7% and global equity markets returning +4.4%. The US versus international stocks spread continued to widen, and outperformance year-to-date is now over 13%. While it may be tempting to chase returns in the higher returning market, these divergences over the past few decades have been cyclical, and we recommend maintaining a globally diversified portfolio.
Quarterly Commentary: US vs. International Markets
One of the most notable trends this year has been the widening out-performance of US stocks versus their international peers. After a volatile beginning to the year due to concerns over inflation, rate hikes, and trade wars, the S&P 500 surged over 7.7% in Q3, significantly outperforming non-US stocks and emerging markets (1). Indeed, this trend has persisted for nearly the entire post-2008 bull market (2). Globally diversified clients have occasionally asked if they should pivot to a full US portfolio because of this out-performance. We caution otherwise.
It is natural to gravitate towards the best-performing parts of the market. Indeed, there is a factor called “momentum” built around the very concept that previous winners will continue winning. Fundamentally, however, it does not make sense for the US to outperform the rest of the world indefinitely. The price to earnings ratio for US vs. non-US stocks continues to widen, which means US stocks are increasingly more expensive(3). According to Bank of America Merrill Lynch, the premium for US vs. global stocks is at its highest since 2009 (4). Historically, these deviations have been cyclical. For example, US stocks under performed global stocks for a full two decades after 1970 (5).
We would also like to note that the rest of the world, on average, tends to grow faster than the United States. The US remains the world’s strongest economy with the best higher education institutions and intellectual property, which means the rest of the world has the natural tailwind of copying what has worked in the US and growing off a smaller base. Over time, the US share of global GDP has fallen and should continue to do so. Global diversification means exposure to these economic trends. While GDP and market growth are not always correlated, saliently illustrated by China’s decoupling of GDP growth versus market returns (6), they are fundamentally related over the long run.
Economic growth is best facilitated by maturing financial markets, which means implementing a system that allows for stable investing. Over time, global market diversification means participating in economic progress. Thus, from both a valuation and fundamental perspective, we recommend maintaining a globally diversified portfolio.
Enjoying Your Wealth
We find it critical that you are well-informed about what is happening in your portfolio because it sets realistic expectations that allows for disciplined long-term investing. The reality is that market variance is unavoidable, which has led many an investor throughout history to overreact because of short-term fluctuations.
Not only is understanding the context of your performance important for long-term financial growth, it is also essential to enjoying your wealth. In his book Solve For Happy, Chief Business Officer at Google X Mo Gawdat expresses happiness as the following equation:
Happiness ≥ Your PERCEPTION of the EVENTS of your life – Your EXPECTATIONS of how life should behave
In other words, if your perception of events is equal to or greater than your expectations, then you are at least not unhappy. Unfortunately, we cannot control global events to the magnitude that we’d like, but we do have some control over perception and expectations (7).
This is precisely why we use an evidence-based investment philosophy. We are able to block out short-term noise, allow markets to work for us, and share insights with clients that help them perceive events through a historical lens and set reasonable expectations in both periods of under-performance and out-performance. We believe that this approach is the optimal way to help you grow and enjoy your wealth as we walk through life together.
I. In Q3, the MSCI ACWI ex-US returned +0.8%, and MSCI Emerging Markets Index returned -1.0%
II. Over the past 10 years, the S&P 500 is up +12% annually versus 8.8% for the MSCI ACWI and 5.7% for the MSCI ACWI ex-US
III. Trailing P/E ratio for the S&P 500 is at 21.1x versus 14.7x for non-US stocks.
V. From January-1970 to January-1990, the S&P 500 underperformed the MSCI World.
VI. China average annual GDP growth since 1992 has been approximately 9.7% versus 1.5% for the MSCI China Index.
VII. Brad Steiman. The Happiness Equation. Dimensional Fund Advisors, September 2018.
The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations. Economic forecast set forth may not develop as predicted. Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.