I had the chance to recently speak with a financial planner who was frustrated with his life’s work managing money for other people. “No matter what I did, I could never beat the S&P 500,” he conceded. This is normally when I share my smug efficient-markets-hypothesis-adherent wisdom, and how active management always comes up short. But as we chatted about his strategy, I realized he was also a believer. His problem, though, was not picking the wrong stocks; his problem was that he was doing everything I thought was right.
Let me explain. Financial theory suggests that investing in the benchmark S&P 500 Index is a good starting point for investors. But doing so leaves you under-diversified. I learned early on that one of the biggest mistakes investors make is home bias, which is investing too much – or even entirely - in one’s own country. Many studies have shown that you’ll get a better return by investing in other countries as well and with less overall risk.
And yet, the raw numbers might suggest otherwise. The S&P 500 has returned an average of 8.7% annually since 1970, compared with 7.8% for the MSCI World Index that includes non-US stocks. Over time, that adds up to a big difference. Plus, the two benchmarks have almost the exact same volatility, suggesting no benefit from global diversification.
Diversification proponents could also argue that the S&P 500 is biased toward large stocks. Sure, smaller companies and those from emerging markets are riskier, but they should grow faster. So, if you want to goose returns by adding a little extra risk, you should ideally add these stocks. Odds are they will outperform over time, albeit with more risk. But that strategy did not work either. The S&P 500 did better and with less volatility.
Was Warren Buffet right all along and you should just invest in the S&P 500 with a bit in bonds as a hedge? Yes — at least so far. Even in investing the future is hard to predict. What stands out about the S&P 500’s superior performance is how much it has been driven by the incredible run of US tech firms in the last 15 years. Whether the S&P 500 continues to outperform may depend on a few large American firms enjoying the same spectacular growth for the next 10 or 20 years too. Perhaps they will. US companies are innovative, and maybe they will disproportionately capitalize on artificial intelligence or whatever else comes along as smaller companies and other countries fall further behind.
But the thing to know about returns is that they are extremely sensitive to the period you are analyzing. Even 50 years of stock data may not tell you very much. And assuming the relatively recent past tells you everything you need to know about the future is a mistake. Sticking with just the S&P 500 requires believing the world changed in the last 15 years and that will be our new reality going forward. There are good reasons to be doubtful.
The outperformance of tech company shares may have been largely driven by historically low-interest rates, and those days are probably over. Their shares have had a bit of a recovery in recent months despite higher rates, likely due to enthusiasm over the prospects for artificial intelligence, but at this early stage, we can’t know the winners. AI may indeed change the world, but in ways that make economic growth more democratic, producing tremendous opportunities for smaller companies and poorer countries, and perhaps leading international stocks to outperform.
Also, the US economy is no sure bet long term. The major investment the government is making in industry and more reshoring may succeed and reduce corporate supply-chain risks, but it could also be distorting the distribution of capital and drag on the economy. The result is slow growth and higher debt. Investing abroad offers some diversification from any one government’s policy.
When structural changes happen in markets and economies, the old rules no longer apply. It may take decades to know when they started, but they do become clear over time. I tried to convince the financial planner that he should stick with his strategy because the future is as uncertain as ever, especially for long-term investors. The best you can do is stay grounded in theory based on decades of data. He was not sure his clients would have the patience to see if he was right.
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