If we could invest by simply looking at what has done well in the recent past – and by that we mean the past few years, not just months – then life would be so much simpler. Unfortunately, rearview mirror investing is not the best way to build portfolios for the future, which is where our spending and intergenerational transfers will take place.
If we take the past three years or so, looking through our rearview lens, we certainly would not want to have too large a position in the UK or emerging equity markets or global commercial property or value or smaller company stocks, which fared poorly on a relative rather than an absolute basis, compared to large companies in overseas developed markets. The latter in turn lagged the broad US market, which in turn lagged the growth-oriented stocks, particularly technology companies. In an extreme rear-view mirror scenario, a hindsight investor would invest heavily in US growth stocks going forward. That would be a very concentrated bet and would ignore the fact that all future growth expectations are captured in todayā€™s prices. These companies need to perform better than these expectations for prices to rise.
The chart below illustrates the rearview investing conundrum by looking at market returns by decade. What is plainly evident is that each part of a sensible portfolio waxes and wanes over time. At the end of the 2000s the rearview mirror investor would have avoided the broad US and World developed markets, yet in the 2010s they were exceptionally strong performers and emerging markets and value stocks suffered relative to the US and the UK was a laggard. To want to place all your investment eggs in one basket – and in particular the one that has just performed best – seems a little naĆÆve. No-one knows what the 2020s will bring and diversification is a key tool in mitigating the unknown.
As such, we take a highly diversified approach when building our clientsā€™ portfolios. We also believe that limited exposure to more risky parts of the markets, including companies in emerging countries, smaller companies, and value (relatively cheaper) companies provide the opportunity ā€“ although never the guarantee ā€“ or delivering returns a little above the broad markets. It can take some time for them to shine through. If an extra return were guaranteed, there would be no risk to picking up the return (and it would not exist).
In an environment when cash delivers a negative return after inflation, and the expected returns for both bonds and equities are reduced as a consequence, these incremental returns are not to be sniffed at. They happen to be all the things that have not done as well (in a relative sense) in the past few years, although they have still delivered strong absolute returns to investors. Rearview investors would avoid them to their detriment. More fool them.
Do not look back and wish you had owned a different portfolio but take comfort from the fact that your highly diversified and soundly structured portfolio gives you every chance of a successful outcome in an unknown, forward looking world.
