2018 Q3 Investment Report Commentary
Diversification: The Only “Free Lunch” Doesn’t Feel So Free Right Now
The best performing strategy year-to-date has been to own the few high-flying stocks that are responsible for the majority of U.S. stock market returns. Against this backdrop, we feel it is an appropriate time to review Daintree’s investment strategy and why we think it has a higher probability of long-term success.
Diversification is often labeled as the only free lunch in investing. The idea is that through diversification, an investor receives a benefit—reduced risk—without lowering returns. Unfortunately, there are times when the taste of this lunch is not satisfying. When stocks rally or markets are narrow, investors can feel over-diversified, and when markets fall, investors can feel under-diversified. Given current markets, many investors harbor that over-diversified feeling.
U.S. equity performance over the last decade has outpaced that of other asset classes (below chart—right side). Recently, the dollar’s strength and trade war concerns have magnified this disparity. However, the post-Financial Crisis era does not reflect historical trends. Over the past ten years, interest rates have been near 0%, GDP growth has been well below the long-term average, and many international markets have struggled to recover while U.S. markets have unabatedly chugged higher. In this environment, investors would do well to remember that asset class performance can, and does, vary over different periods (below chart—left side).
Many investors—and people in general—exhibit recency bias, or the psychological phenomenon of recent events featuring more prominently in decision-making than events of the further past. In the investment world, this manifests as the belief that U.S. markets (or a group of stocks—e.g. “FAANG”) will continue to outperform because they have done so in the short-term. An investor that adopts this mindset could abandon diversification in favor of a U.S. concentrated portfolio. This is not a prudent investment decision for a long-term investor. It does not take into account historical performance, risk tolerance, or the (unlikely) probability of success.
As shown below, diversification beyond a U.S. concentrated portfolio does not work in every year. Over the long-term though, it has a higher probability of success. Since 1987, a globally diversified portfolio has outperformed in 17 of the 31 years (bars above the line). Additionally, a diversified portfolio achieved an annualized return of 9.8% versus 9.2% for a U.S. concentrated portfolio, even though the diversified portfolio has consistently lagged in recent years. This performance differential may seem slight, but a $1 million dollar globally diversified portfolio would have earned almost $3.3 million more over the full period since 1987.
With diversified portfolios, we know that modest tactical shifts among asset classes can lead to further improved results. Below is a valuation metric highlighting the current disparities among global equity geographies. We use many valuation metrics to determine opportunities, but the Shiller P/E (price-to-earnings ratio) provides a good snapshot of the overall environment. Using the Shiller P/E, one can see that U.S. equity valuations are elevated relative to history (the red triangle is well above the yellow diamond and blue box). Conversely, Non-U.S. equity valuations for EAFE (Europe, Australia, and Far East) and EM (Emerging Markets) remain more reasonable relative to history. As such, our portfolios maintain a slight overweight to Non-U.S. equities. That said, our Investment Committee continues to review markets for new opportunities and we will implement changes as appropriate with risk and return expectations.
Positioning and Outlook
In summary, we favor stocks over bonds slightly, Non-U.S. Equities over U.S. Equities due to relative valuations, Non-Core Bonds over Core Bonds due to rising interest rates, and a healthy dose of both Diversifying Strategies and Real Assets in portfolios.
Economic data remains strong across most geographies, inflation seems under control, lending and credit seems to be growing appropriately for this point in the economic cycle, and central banks are finding the right balance as they consistently increase interest rates. Yet we readily admit that we are in the late innings of the post-crisis economic cycle, so we are extra diligent watching for any change that would cause us to alter our tactics.