January 28, 2015

Focusing on Short-Term Returns can be Hazardous for your Wealth

Imagine investing in an asset that has increased in value by 14.8% per year over the last three years. This asset also had a positive return when U.S. stocks fell last September.

Can you guess what asset class this was? The answer: International stocks in their own local currency returns (represented by the MSCI EAFE NR LCL).

So why do so many investors feel like international stocks have not performed well recently?

Changes in currency:

  • The 14.8% three-year annualized return is the performance on the stock markets around the world in their own relative currencies. However when translated back into U.S. Dollars, that return falls from 14.8% to 9.7%.
  • The 5% difference in returns can be attributed to a strengthening dollar.
  • The U.S. Dollar strengthened by nearly 7% in the 3rd quarter of 2014 and has gained nearly 20% over the previous three years, creating a strong headwind for International returns when translated back into U.S. Dollars.1
  • Economic conditions and forecasts for future interest rates have risen faster in the U.S. compared to the rest of the world, and as a result the U.S. Dollar has strengthened. The comparison with U.S. stock performance:
  • Over this same three-year period the S&P 500 returned a resounding 19.8% per year.
  • For the year through October the S&P 500 was up 11.0%, compared to an MSCI EAFE NR USD return of -5.1%
  • The returns on large cap U.S. companies most investors are familiar with are much more visible than International companies.

Given the strength of the U.S. Dollar and the lackluster performance of International stocks year to date, should investors shift to a heavy home bias in their portfolios?

Not if history is any guide.

A large benefit of investing in a globally diversified portfolio is that different asset classes will outperform at different times. For example the Dow Jones US Select REIT index lagged most other stocks last year, returning just 1.2% compared to the S&P 500 2013 return of 32.4%. Yet in 2014, REITs have outperformed the S&P 500 by 15%. Investors who rebalanced or added money into an account last year were able to buy additional REIT shares at lower prices and participate in the large gains seen this year.

While International investments have underperformed relative to domestic stocks in recent periods, there are many periods when the opposite is true, such as the mid-2000s or 1970s.

We don’t know which asset classes will do best in the coming month, quarter or year. But we do know that investors have been well served by having a globally diversified portfolio which maintains exposure to numerous asset classes through the ups and downs they will all inevitably face.

1 2014 Morningstar Direct, Federal Reserve Bank of St. Louis database

Source: Morningstar Direct 2014. Market segment (Index representation) as follows: U.S. Large Cap (S&P 500 Index), U.S. Value Stocks (Russell 1000 Value Index), U.S. Small Company Stocks (Russell 2000 Index), U.S. Real Estate Market (Dow Jones U.S. Select REIT Index), International Developed Value (MSCI World Ex USA Value Index (net div.)), International Small (MSCI World Ex USA Small (net div.)), Emerging Markets (MSCI Emerging Markets Index (net div)), Global Bonds (Citi WGBI 1-5 Yr Hdg USD), US Bonds (BofA ML Corp & Govt 1-3 Yr TR).

Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio.

Diversification neither assures a profit nor guarantees against loss in a declining market.

Past performance is not a guarantee of future results. All investments involve risk, including loss of principal. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting.

Stock investing involves risks, including increased volatility (up and down movement in the value of your assets) and loss of principal. Investors with time horizons of less than five years should consider minimizing or avoiding investing in common stocks. Real estate securities funds are subject to changes in economic conditions, credit risk and interest rate fluctuations.