Everyone has a different perspective on people, values and philosophies they want to help guide them in life. As we grow and learn, we realize some associations or ideas we have had are unreliable; wisdom in part should be the letting go of these, replacing them with reliable associations. Reliability can be known both experientially and theoretically. Over time, you might have learned that certain people in your life are characteristically unreliable because of their actions. Alternatively, scientists tested the reliability of Einstein’s theory of general relativity over time and found it to in fact be reliable in most cases and thus something of value. These are examples of experiential and theoretical validations of reliability.
When I was a teenager, we would often depart my hometown of Coronado, CA. at 4:30 a.m. to go surfing in Mexico before school. This was before the era of cell phones, so we had to plan these excursions in advance and it was critical that you were ready at 4:30 a.m. sharp. Waiting in the darkness outside of your house with $1.50 in your pocket for gas and taco money, board and wetsuit in hand, you’d look for a pair of headlights to penetrate the salty fog, signaling the beginning of the journey. But, if you were still sleeping or not ready, you would be left behind and flagged as unreliable — missing the morning surf at Baja Malibu or nearby Baja reef break, surfing with the sun rising, and the occasional dolphin or whale breaching close by on a secluded beach. Reliability had consequences for us surfers even at an early age and you would be uninvited if you were habitually not ready to roll. Full disclosure, if the waves were really good, there might have been a few times we missed morning classes and despite the remedial consequences, it was well worth it.
With this, I’ll go out on a limb and conclude that reliability is an extremely important characteristic for us all. Interestingly, though, reliability of investment returns does not come into the conversation often for most investors, but it should be at the top of everyone’s list.
As it turns out, investment diversification significantly affects the reliability of outcomes. In a recent paper entitled, How Diversification Impacts the Reliability of Outcomes by Wei Dai, Ph.D., senior researcher at Dimensional Fund Advisors, it was found that “…broad diversification combined with long-term investing is critical to improving the the reliability of investment outcomes.” That should be one of the core characteristics of investment portfolios: improving the reliability of outcomes. How much value is an investment strategy to you when the outcomes are not so reliable?
Rather than dig into the technical aspects of the paper, I’ll give you a glimpse of Dr. Dai’s explanation of how we can analytically derive the chance of outperformance:That’s enough of that; let’s pivot to more understandable bullet points.
- Higher returns than the market can be achieved by capturing certain factors, and broad diversification helps improve the reliability of capturing those factors.
- “Diversification” should include diversification of industries, sectors and countries.
- The diversification should be as broad as possible.
The key to all this is knowing how broad your diversification should be. The paper states that to get the highest reliability, you should have the broadest diversification, broad being a relative term.
Most investors might say they are diversified, but they really have no idea to what extent. Measuring the breadth of your diversification is rather straightforward. If you hold individual stocks and bonds you would simply add them up. If you hold mutual funds, you would note the number of securities those mutual funds hold. Your portfolio might hold 50, 150 or a few thousand securities. In all these instances, the research tells us you are still not diversified enough to make your portfolio as reliable as possible.
As a reference point, WorthPointe’s Precision Model Portfolios hold over 12,000 individual securities. Comparing that to investors who own several hundred or even several thousand securities, you can see how most folks fall well short of taking advantage of the science of investing that leads to reliability. We have effectively allocated our client portfolios as broadly as possible, which can help maximize the reliability of their outcomes. Hopefully, this is knowledge that will bring an added level of comfort in a world of unreliability.
As another reference point, we can look at Vanguard’s Global Equity Fund (VHGEX), whose product summary states, “This fund invests in companies of various sizes from all over the globe, with the United States representing about 40% of its assets. The portfolio is made up of 800-plus stocks from more than 20 countries.” Most investors invested in this global stock fund that owns 1,275 stocks will emphatically state they are very well diversified and have no need for any further improvement, but the research tells us differently.
There are other benefits to be gained from broad diversification, namely a reduction in unnecessary turnover, which is related to tax-efficiency and lowering transaction costs through flexible and patient trading — both of which we are able to take advantage of in our client portfolios.
If you previously had not heard of the reliability benefits derived from broad diversification, chalk it up to my continued efforts to highlight the brain-space referred to as “Things you don’t know you don’t know.” If I can fill in the blanks, I’m doing my job.
Reliability, a cornerstone in life and investing, will be a key to improving your probabilities of success in the future and now is a good time to maximize your efforts and not miss out on the next wave.
2017 Q1 Index Review
(Table disclosures and https://www.worthpointeinvest.com/disclaimer/) performance for periods greater than one year are annualized. Selection of funds, indices and time periods presented are chosen by the client’s advisor. Indices are not available for direct investment and performance does not reflect expenses of an actual portfolio. Past performance is not a guarantee of future results. Russell data copyright © Russell Investment Group 1995-2013, all rights reserved. The S&P data are provided by Standard & Poor’s Index Services Group. MSCI data copyright © MSCI 2013, all rights reserved. Barclays Capital data provided by Barclays Bank PLC.)
All the indicated indices were in positive territory for the last three months, which bodes well for investor return for the first quarter of 2017. The best performing asset class, emerging markets, led the indices for the quarter, returning 11.49%. With regard to geography, the order of precedence from highest returns to lowest is as follows: emerging, U.S., international developed, global real estate, bonds. Since we’re on the topic of country markets, the best performing country index for the quarter was India at 18.85%, while the worst performing country index was Russia at -4.32%.
In the U.S.,value underperformed growth indices and small caps underperformed large caps reversing the trend of recent quarters. Some of the interesting U.S. macro-headlines for the quarter were “Housing Starts Jumped in December Capping Best Year since 2007,” “Dow Closes above 20,000 for First Time,” “US Trade Deficit Last Year Was Widest since 2012,” “Housing Starts Rise to 10-Year High,” “Fed Raises Interest Rates Remains on Track to Keep Tightening,” “Dow Suffers Longest Losing Streak since 2011,” and “US Consumer Confidence Reaches Highest Level since 2000.”
Imagine trying to implement a “manage by headline” investment strategy and getting yanked around in different directions on any given day. This is a strategy that sets people up for disappointment. Headlines affect almost every investor’s perception of where the markets are headed; it takes a disciplined investment process and behavioral coaching to help ensure bad decisions aren’t made based on these perceptions.
Interest rates were mixed across the U.S. fixed income market during the first quarter of 2017. The yield on the 5-year Treasury note was unchanged, ending at 1.93%. The yield on the 10-year Treasury note decreased 5 basis points (bps) to 2.40%. The 30-year Treasury bond yield decreased 4 bps to 3.02%.
The yield on the 1-year Treasury bill rose 18 bps to 1.03%, and the 2-year T-note yield increased 7 bps to 1.27%. The yield on the 3-month T-bill increased 25 bps to 0.76%, while the 6-month T-bill yield rose 29 bps to 0.91%.
Despite all this, the indicated bond indices were in positive territory for the quarter.
In summary, investors should show robust performance returns in their portfolios for the quarter with variations based on equity and fixed income exposure. If your investments did significantly better or significantly worse than the indices, it’s an indicator you might have more speculative exposure than you think and would be worth reviewing.
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