There seems to be a lot of focus in the financial media lately about what will happen next: with interest rates, inflation, the economy, the dollar, etcetera.
If this is your only source of financial insight, it’s understandable that you may think that this is how you’re supposed to invest—come up with a forecast about the future and act upon it. Then, when that forecast changes, update your portfolio. I wouldn’t be surprised, however, if just reading this exhausts you and has you thinking that, hopefully, there’s a better way to invest.
Fortunately, there is.
If you adopt a well-diversified portfolio—one that holds thousands of stocks across dozens of countries as well as different kinds of stocks: small and large companies, value and growth companies, as well as moderate and higher profitability companies—and stick with it, you might find that forecasting and the constant reshuffling isn’t required.
Let’s look at an example of such a portfolio, the Dimensional Core Plus 100/0 Wealth Index (100% stocks, 0% bonds). Going back as far as Dimensional provides data, from 1985 through June 2022, the index has averaged 11% per year through the ups and downs. Not too bad.
Could you have done better?
What if you knew, back in 1985, that the US stock market would outperform international stocks by a wide margin over this stretch? I’m not sure how you would have known this; the surge in the Japanese economy still had several years in the late 80s to run, and looking back over the prior 15 years, the MSCI World ex-USA Index had outperformed the US stock market (CRSP 1-10 Index) by almost 2% per year.
But let’s say that you did know. Would taking a big bet and investing all of your money in the US market—as measured by the Russell 3000 Index—result in you being much further ahead? Surprisingly, no.
Even though international stocks underperformed US stocks by almost 3% per year over this period, the globally diversified Dimensional Core Plus Wealth Index matched the return on the US index. Even with perfect foresight, picking one of the best country stock markets over this entire 37+ year stretch didn’t result in better returns than simply holding a globally diversified portfolio.
How could this be? Credit the second part of diversification—the Dimensional Core Plus Wealth Index intentionally had a greater emphasis on smaller stocks, lower-priced value stocks, and more profitable stocks than a traditional market index fund like the Russell 3000, as those companies have higher expected returns.
Now let’s take our forecasting assumptions one step further.
Imagine you knew back in 1985 not only that US stocks were going to have higher future returns, but you were also aware of the expected premium for holding smaller value stocks. So instead of just owning the US market, the Russell 3000 Index, you invested everything into a retail index of US small value stocks—the Russell 2000 Value. Of course, this would have been a winning bet? Again, no go.
Over this period, small value stocks, as defined by the Russell Index family, actually underperformed the market. The Russell 2000 Value Index returned 0.6% per year less than the Russell 3000 Index and the Dimensional Core Plus Wealth Index. Even knowing what was supposed to be the best-performing corner of the market in one of the best-performing countries in the world didn’t give you a leg up on a diversified portfolio.
Finally, let’s say you knew in 1985 that despite an 11% per year compound return, you’d have to suffer through several painful short-term declines to get that return, including a double-digit drop in just the last 12 months. You probably should have known this much, as the history of stock investing is replete with these downturns.
Once again, I’d argue that forecasting wasn’t required to be successful or limit short-term losses. If you wanted less dramatic swings in your portfolio value and were willing to accept lower long-term returns, adopting a balanced allocation of stocks and bonds was a far better option than trying to time when to be in stocks and when to hide out in cash.
Looking above at all the 12-month periods ending in June of each year through 2022, we see a noticeable decrease in the temporary declines as we move from the 100/0 all-stock index allocation to the 80/20 and 60/40 stock and bond index allocations.
If you had more modest long-term return goals, these balanced stock and bond allocations might have been sufficient—the 80/20 Index returned over 10% per year, and the 60/40 Index over 9% per year. Each of these allocations matched or outperformed the all-stock MSCI World Stock Index without greater volatility, making it easier to stay the course.
There is a better way to invest to achieve your long-term wealth goals. One that doesn’t require you or your advisor to know how to forecast what will happen next in the markets or the economy.
Instead, holding a balanced, diversified portfolio appropriate for your objectives and sticking with it during difficult times can be a superior solution. Especially if that portfolio emphasizes smaller, lower-priced value, and higher profitability stocks. It will likely work much better than trying to predict the next investing theme or fad, and you’ll have greater peace of mind knowing you don’t have to watch every movement in the market for your next buy or sell signal. And who couldn’t use a little less stress in their life?
If you want a 2nd opinion on your current investing plan or want to learn more about how this forecasting-not-required Dimensional Investing approach can work for your long-term goals, schedule a time for a short introductory chat with me here.
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Dimensional Core Plus Wealth Index Report—2021.
Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.