Normally I say not to pay attention to short-term returns. You're a long-term investor, so recent results shouldn't have much influence on you one way or another. But few 12-month periods are as erratic or educational as the last year, so I am going to make an exception.
March 23rd, exactly one year ago, turned out to be the low point for stocks during the "Covid Collapse." Although it was not at all evident at the time that we had hit bottom. The lockdowns had only begun a week or two earlier in much of the US, and if there was seemingly a worse time in modern history to stay invested in stocks -- having already seen a -34% decline on the S&P 500 in 33 days, the quickest plunge of that magnitude on record -- I don't remember it. But it turned out, as it so often has during particularly dark times, that staying invested was the best course of action. We never retested the March 23rd lows, and stocks over the last year are up spectacularly. The S&P 500 in particular has gained +74.0%, one of the best yearly gains you'll see on stocks in your lifetime.
Lesson #1 from the last year is this: Predicting the short-term direction of stocks is extremely difficult and almost no one can do it consistently. Stop trying. If you own stocks because you need their relatively high long-term potential returns, then hold them for that reason and ignore what they're doing in the short run.
But the returns on the S&P 500 don't tell the whole story. The chart below looks at the 12-month returns across a suite of global stock asset classes that comprise the Dimensional Equity Balanced Strategy, a well-diversified allocation that emphasizes smaller and lower-priced value stocks. The "Large Company Fund" at the bottom of the chart is the S&P 500. As you can see from the results, most asset classes did much better than US large cap growth stocks (S&P 500) over the last year. US large value stocks, for example, gained +87.2%, the smallest US stocks, represented by the DFA US Microcap Fund, gained almost +127%, and the very best return came from US small cap value stocks, with over a +140% return! The small cap and value "premiums" you always hear me talking about were some of the largest in modern times.
Even international and emerging markets stocks outperformed the S&P 500 -- for example international small cap value stocks gained +89.2% and emerging markets gained +78.1% while small cap emerging markets stocks did much better, gaining +93.8%.
Lesson #2 is that different stock asset classes can have dramatically different short-term returns. Sometimes US large cap growth stocks are the best performing asset class, as was the case from 1998 to 1999 and 2017 through mid 2020. But quite often, other asset classes are performing better. Holding a diversified portfolio of asset classes and rebalancing periodically means that you can take advantage of the random short-term ebbs and flows of different categories, leading to a higher long-term return with less risk than the average of the individual holdings.
The last lesson builds on the second one.
Would you have predicted a year ago that US large cap growth stocks would have been one of the worst performing asset classes in the market over the next year? Probably not. They had been doing so well that their relative superiority seemed to almost be a sure thing. Holding value stocks, or small cap stocks, or international stocks, seemed destined to stay unprofitable.
But while growth stock prices were ascending over the last few years, their values compared to their earnings were becoming significantly over inflated, while the sub-par returns of almost all of these other asset classes during prior years meant that they were becoming increasingly better values. At some point we were destined for an asset class rotation or reversal out of large growth stocks. Over time, value, small cap, and small cap value stocks globally have much higher expected returns, so the fact that they had underperformed over the last few years meant they had even more ground to make up.
As I mentioned in my last blog, bailing on a diversified portfolio -- in this case the Dimensional Equity Balanced Strategy -- in favor of the "safe" and familiar confines of large US growth stocks (S&P 500/DFA US Large Company), would have been incredibly expensive. The Equity Balanced strategy has gained +93% in the last year, almost 20% more than the S&P 500. If you want to have any chance of achieving your long-term goals, you cannot afford to mis-time the market and sacrifice 20% in potential returns you would have earned if you just stayed disciplined.
The final lesson, #3, is that you have to trust your investment philosophy and process, which means you have to continue to stick with it when it isn't "working" as well as you would hope. Once you've made the sensible decision to diversify broadly according to your return goals and tolerance for portfolio volatility, you have to ride out the rough patches, and even lean in to them by buying more of the recent underperforming asset classes. That's simple when we say it, "buy low and sell high." Unfortunately, it's much harder to pull off in practice.
This is why, if there was a fourth lesson, it would be: If you are honest with yourself and your (in)ability to stay disciplined during difficult times, your best investment might just be hiring a full-time financial advisor who can not only help you create an appropriate plan for your long-term goals and populate it with the best investments, but also keep you focused on the long-term and keep you from reacting irrationally when markets are erratic.
We've been on quite a ride over the last year, and rarely has it been very fun. But if we can remember the experience, and learn from it -- celebrate the things we did well and learn from the things we should have done differently -- it can be a tremendously valuable experience. In that sense, we should be grateful for the lessons from the last 12 months.
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.