Won’t Get Fooled Again
“Then I’ll get on my knees and pray
We don’t get fooled again.
Don’t get fooled again.
— The Who, 1971
As the investment officer at Redwood, the most common question I hear is, “How is the market doing?” It’s an ambiguous question that inevitably causes me to ask, “Which one? The American stock market? European? Asian? South American? Bonds? Commodities?” We invest in so many “markets.”
Given media reports about how the market is at record highs or how the market may react to the declining price of oil, the confusion is understandable. These statements often are referring to the S&P 500 or the Dow Jones industrial average. But those two markets represent only the 500 largest American companies and 30 select American companies respectively. At Redwood, we invest in over 10,000 stocks and 30 different countries.
Given that the Dow and S&P 500 reached all-time highs in 2014, what concerns me today is that people will fall into the same trap investors experienced during the 1990s – a decade-long bull market in U.S. large-company stocks. In other words, many investors will mistake short-term success for smart, long-term strategy.
As I said, the S&P 500 represents a small sample of large-company stocks in the U.S. market – a stock market contains around 4,000 companies, however. Moreover, it leaves out another 5,000 stocks worldwide. As a result, the S&P 500 only represents a select number of large corporations in the U.S. and just 5% of all stocks globally. The media’s reports of “the market” also exclude thousands of small and mid-size company stocks as well as every other stock market in the world. Thus, to call the S&P 500 a representation of the market is a major stretch.
At Redwood, we think globally and consider all companies worldwide to be investment opportunities. Who wouldn’t want BMW, Samsung, Toyota, British Petroleum, and Nestle in their portfolio? If you only invest in the S&P 500, you’ll miss thousands of great companies like these. So when we and our clients invest in the stock market, it’s the global stock market; not just 500 large-company stocks domiciled in the U.S.
As noted in the title of this article, the classic rock band The Who had a famous song called Won’t Be Fooled Again – a message that applies here. The past several years feel like the 1990s when the S&P 500 went off the charts, averaging over 18% per year for 10 years, while international stocks only churned out 7% per year during the same period.
At the time, people were mocking Warren Buffet and other diversified investors for not having all of their money in 500 American companies. Like Buffet, we, at Redwood, believe that a prudent investor always spreads out his investments into small and large U.S. and international companies in addition to bonds and alternatives.
Unfortunately, in the 90s, others did not agree. Individual and institutional investors, attracted by the good returns of one market, shunned all other markets like U.S. small-company stocks and international stocks. Going against the grain was met with skepticism and many people put all their eggs in one basket.
The chart above shows $1 invested in the S&P 500 stock index compared to a well-diversified portfolio of small and international stocks and bonds. For a short time following that, S&P 500’s pied piper had them singing a happy tune. But, as always, the music stops. And when it did, the silence was deafening to undiversified investors. That pretty blue line in that graph above looks like it’s going straight to the moon, but it changed course quickly.
The blue line in the chart below shows that an investor with his money in the S&P 500 from 2000 to 2010 would have lost 20% of it. Investors with undiversified portfolios were understandably frustrated. They did what they thought was smart; they invested for the long term (10 years) and
The green line in the chart below shows that an investor with a diversified portfolio, like the one we create at Redwood, would have doubled his money during the same time period (2000-2010). Only the investor with all her money in one market got lost on the road to financial freedom.
So while it’s understandable to see one market doing well and want more of it, the real objective is to both avoid unnecessary risk (e.g., overconcentration in one area) and earn the best returns.
As noted in the chart below, during the 20-year period shown (1990 -2010), you would have had 40% more money at the end of 2010 if you were invested in a “diversified” portfolio versus an investment in the S&P 500. Countless people made the mistake of not being diversified and paid dearly. They simultaneously took on more risk and earned substantially less money. That doesn’t make any sense.
As we bid adieu to 2014 and enter a new year with Dow stocks outperforming every other asset class for the past two years (+50% versus the international index up only 19% during the same period), it’s understandable to think more money in one market, the S&P 500, is attractive. Feeling that way doesn’t make you dumb; it makes you human. But in the investment world, what feels good often is not the right move.
Meet the new boss; same as the old boss. Stay diversified and invest for the long term. Don’t get fooled again.
Lane Steinberger, CFA, CFP®
Partner, Chief Investment Officer