Tuesday, January 23, 2018

Review Your Investments "Periodically"

Most high school students are exposed to the periodic table of the elements in their science classes.

Anyone interested in investing should "periodically" review what is often called the "asset allocation quilt" that bears a strong resemblance to that periodic table.

The asset allocation chart typically shows ranked returns for the major asset allocation categories by year in a colorful array covering the last decade.

This is the most recent chart that encompasses returns for 2017 and looks back to that ugly, ugly investment year of 2008. Ben Carlson who writes the blog, "A Wealth of Common Sense" calls it his favorite performance chart of 2017.

Credit: AWealthofCommonSense.com

Here is a periodic table of the elements. Do you see the resemblance?

What is the value in "periodically" looking at the asset allocation quilt?

I think the biggest benefit is that it provides the investor with perspective. It is easy to lose the forest for the trees in investing. Viewing this chart periodically allows you to grasp the big picture unfolding around you in the investment world.

In looking at the quilt chart above you see that there is no investment class that is on top every year. In fact, at times you see the worst performing asset class in one year become the best performing asset class the next year. (EM-Emerging Markets in 2011 and 2012). Or you see the best performer in one year sink near the bottom the next. (Bonds in 2008 and 2009).

This particular chart also shows what a solid run we have had over the last ten years despite the horrific results in 2008 when Mid Cap stocks lost 36.5% for year and still had the fourth best "performance" for the year.

In fact, in both 2016 and 2017 there was not one asset class that had negative performance. Compare that to 2008 when there were only two asset classes (bonds and cash) that were positive.

Those horrible results in 2008 still did not prevent all asset classes (except Commodities) from producing positive returns over the 10 year period.

If you take away the 2008 results, the nine year returns have been fantastic as long as you did not have too much in cash and you avoided commodities.

The longer-term returns shown here also once again prove that the best asset class for younger investors is small cap stocks. Over long periods of time (10 years and beyond) this asset class has consistently produced the strongest returns over almost all longer periods. This is even more particularly true of small cap value than small cap growth stocks.

If you are under the age of 45 you should probably overweight small cap stocks in your portfolio. You have time on your side to reap those additional returns. Small cap stocks will be more volatile along the way but history suggests you will be rewarded over the long term for that additional risk.

Looking at the chart it is also hard to ignore how long commodities have been out of favor. This has been due to deflationary forces in the world economy but as we begin to hear more about hints of inflation you have to think commodities are due for a turnaround. It is not often that you see any asset class stay down that long relative to other investments.

Carlson the following as other reasons that this is his favorite performance chart. They are all great reminders for any investor.

  • It reminds me to stay humble. Predictions about the top (or bottom) performing asset classes in any given year are hard. There are probably some rules-based strategies to sort these asset classes to do a little better than a simple strategic allocation but there are many ways in which to do worse by trying to select the best one year in and year out.
  • It reminds me to think and act for the long-term. Charley Ellis once said, “The average long-term experience in investing is never surprising, but the short-term experience is always surprising.” One-year performance numbers don’t really tell you a whole lot. Even the 3- and 5-year numbers can be misleading in most cases so it takes a lot of discipline and patience to be an actual long-term investor to think beyond short-run performance numbers.
  • It reminds me how random markets can be. Sometimes the worst performer in one year becomes the best in the next year and vice versa. Sometimes these asset classes go on hot or cold streaks and put together a string of solid or subpar performance. Cash makes for a lousy long-term investment option (especially at current rates) but can be a top performer when risk assets sell-off. Even 10 years can show terrible returns on your stock investments (see international and emerging markets over the past 10 years as a perfect example).
  • It reminds me of the importance of diversification. Diversification is a boring way to invest but it’s the simplest form of risk control for those who would like to avoid going broke or losing their mind in the markets. You’ll never get rich overnight by diversifying but you’ll never lose it all overnight either. When markets are rocking (as they have been wont to do of late) diversifying makes you feel silly but there will come a time when it comes in handy.
  • It reminds me of the importance of understanding the concept of mean reversion. No asset class outperforms always and forever. It may have felt like international stocks or emerging markets or even commodities were dead money in recent years as they all got destroyed by U.S. stocks. Eventually, these cycles turn, often before you can prepare for it or find a legitimate reason for it.
  • It reminds me how vast the investment universe is. This is a fairly broad group of asset classes. There are many more options available to investors these days beyond this group. I could’ve created one of these using sectors, countries, risk factors, alternative investments or hundreds of different variations. Last year someone took my quilt and added Bitcoin to the mix. Creating an asset allocation is the easy part. Being content with the portfolio you choose and avoiding the temptation to constantly tweak it and make changes is the difficult part.

Look at the chart above one more time.

What might it suggest for your own investments?

Don't forget to periodically review new versions of the chart in future years to stay on track.

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