Better Investment Experience – Part Three

Consider the Drivers of Returns & Practice Smart Diversification

March 2019

This is the third of a five-part series that will help you have a better investment experience. This isn’t a deep-dive into investing or the markets, but rather some basic concepts that investors often lose sight of.

Consider the Drivers of Returns

Rather than viewing the market universe in terms of individual stocks and bonds, investors should define the market along the dimensions of expected returns to identify broader areas or groups that have similar relevant characteristics.

This approach relies on academic research and internal testing to identify these dimensions, which point to differences in expected returns.

In the equity market, the dimensions are size (small cap vs. large cap), relative price (value vs. growth), and profitability (high vs. low). In the fixed income market, these dimensions are term and credit quality. The return differences between stocks and bonds can be considerably large, as can the return differences among a group of stocks or bonds.

Dimensions of Expected Returns

Academic research has identified these equity and fixed income dimensions, which point to differences in expected returns.

Investors can pursue higher expected returns by structuring their portfolio around these dimensions.

To be considered a dimension, it must be sensible, backed by data over time and across markets, and cost- effective to capture in diversified portfolios.

In a dimensions-based approach, capturing returns does not involve predicting which stocks, bonds, or market areas are going to outperform in the future. Rather, the goal is to hold well-diversified portfolios that emphasize dimensions of higher expected returns, control costs, and have low turnover.

Practice Smart Diversification

Many people concentrate their investments in their home country’s stock market. They might consider their portfolio diversified when they choose a large group of US stocks or US mutual funds. In some cases, they may hold only a small group of US securities.

Yet, from a global perspective, limiting one’s investment universe to a handful of stocks, or even one stock market, is a concentrated strategy with possible risk and return implications.

This depiction below offers a conceptual comparison of investing only in the US market, as represented by the S&P 500 Index, and structuring a globally diversified portfolio that holds assets in markets around the world, as represented by the MSCI All Country World Index (IMI). For the global portfolio, holding thousands of stocks across the world’s developed and emerging market countries broadens one’s investment universe considerably.

US-Based Mutual Fund Performance, 2003–2017

Holding securities across many market segments can help manage overall risk. But diversifying within your home market may not be enough. Global diversification can broaden your investment universe.

The benefit if this type of diversification is that when a market in one country or region suffers, the loss can be minimized by the other markets. For example, the London Stock Exchange (LSE) has been suffering because of Brexit uncertainty. If one has had investments in only the LSE, then those investments would be heavily impacted by whatever fluctuations the LSE has had. However, with global diversification, the impact would be less.

The overarching idea is that global diversification is important as is well-researched dimensions that have higher expected returns. By following through on these principles, investors can feel good about the solid platform on which their investments are based.

Monson Wealth Management Flat-Fee Program

Most Registered Investment Advisors charge a percentage of assets under management, which translates into the more money you have, the more you are charged, even though the servicing time may be the same as someone who has one-quarter of what you do.

Our Flat-Fee program is designed with these clients in mind. We don’t charge you more just because you have more.

Give us a call and in 15 minutes we can assess your situation to see if this makes sense for you.

“The MWM Flat-Fee Program is designed to give clients that have over $500k invested a fair shake.”

– Eldon Monson CFP®, RICP®