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.
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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.
Read the full article here by Allison Schrager, Advisor Perspectives.
