The more risk you take, the more money you’ll earn — if you live long enough. History shows that it can take decades for stocks to outperform.
Making money in stocks can take a long time. A $10,000 investment in the S&P 500 during April 2000 grew to only $10,306 by October 2011. A similar investment in 5-year Treasury notes grew to $20,920 over the same period. U.S. stock prices must double in value to close this gap. That may take years.
International stocks have been popular over the past decade as investors seek to diversify their U.S. holdings. Ironically, international stocks have lagged the U.S. market for decades. Since 1988, a $10,000 investment in the S&P grew to $75,570 while a similar investment in the MSCI EAFE (net dividends), a broad measure of developed foreign country stocks, grew to only $24,720. That’s 23 years of underperformance and counting.
Investing in small-cap value stocks has become another popular strategy in recent years. This tiny market segment has tripled in value since 2000 while large-growth stocks have suffered. But it’s not always sugar and honey for small-cap value investors. This niche investment style lagged large-cap stocks for 17 years starting in 1984.
It would be nice to own a crystal ball that tells us when a market will move, for how long and by how much. Hawkers of market-timing services claim to have such a device and they will sell you their predictions for a fee. But wise investors know that crystal balls do not exist. What works is time in the market. The question to ask is how much time is needed and if you have that much time?
The number of years it could take for a risky asset class to outperform T-notes or another less risky market will astound you. I ran some numbers on a few asset class pairs to measure this period. The following paragraphs highlight the three longest periods it has taken one risky asset class to catch up to a second asset class, once the first asset class started to underperform.
Table 1 compares the S&P 500 total return to 5-year Treasury notes. An investment in the S&P 500 during September 1929 would have trailed an investment in 5-year Treasury notes until September 1950. That’s 253 months of underperformance — more than 21 years of waiting.
Table 1: S&P 500 Total Return versus 5-year Treasury Notes (1925-2011)
The last column in Table 1 is a balanced portfolio that is invested 50 percent in the S&P 500 and 50 percent in 5-year Treasury notes. Monthly rebalancing to that target allocation was employed. One benefit of rebalancing is a reduction in time to reach parity — but it’s still a long wait.
The second and third longest periods of underperformance for the S&P 500 are shorter than 21 years, at least until this point. A 12-year lag occurred from January 1968 to November 1980, and so far this period there has been more than an 11-year lag. The S&P 500 has to gain more than 100 percent in total return to catch up to T-notes. Who knows how long that will take?
Table 2 measures small-cap stocks relative to large-cap stocks. I used firm size data available from Ken French’s database because the two size indices are mutually exclusive, meaning there are no overlapping stocks. Small-cap investing pays, eventually.
Table 2: Small-Cap U.S. Stocks versus Large Cap U.S. Stocks (1926-2011)
Small-cap stocks have more risk than large cap stocks and have outperformed over time. But the wait can be very long. More than 27 years of underperformance occurred between 1983 and 2010 and nearly 20 years of lagged performance occurred from 1946 to 1966. A portfolio holding 70 percent large-cap stocks and 30 percent small-cap stocks cut the time down slightly.
What if you bought small-cap “value” stocks rather than just small-cap? This has become a popular strategy in recent years because small-cap value stocks more than doubled in value between 2000 and 2006. Table 3 provides a different picture. The analysis is based on the Dimensional U.S. Small Cap Index because it goes back to 1927.
Table 3: Large U.S. Stocks versus Small Value Stocks (1927-2011)
The longest period of underperformance for small value stocks was 18 years, from February 1984 to June 2001. The average for all three lagging periods was 13 years, an improvement over just small-cap, but still a long time to wait.
International equity investing has been very popular in recent years. We are constantly told about the benefits of global diversification. International markets are divided into developed countries and emerging market countries. The MSCI EAFE index is a standard benchmark for developed markets and the MSCI Emerging Markets index is a standard proxy for emerging countries.
I was surprised by the number of years it can take for international stocks to help a portfolio. Table 4 highlights developed market stocks and Table 5 highlights emerging market stocks.
Table 4: MSCI EAFE Index (net dividends) versus the S&P 500 (1970-2011)
The blank end dates in Table 4 occur because underperformance is still going on. Since December 1988, the total return of developed market countries has been below the S&P 500. Figure 1 illustrates how large the gap is. It shows the cumulative results of $1 investing in the S&P 500 and MSCI EAFE (net div) over the time period.
Figure 1: S&P 500 and the MSCI EAFE (net div) Returns since December 1989
Emerging markets have had their day in the sun recently, but it hasn’t always been sunshine. Table 5 summarizes three periods of underperformance of emerging market stocks, relative to the performing EAFE index. These lags in emerging markets occurred while developed markets underperformed the U.S. market.
Table 5: MSCI Emerging Markets versus MSCI EAFE (1988-2011)
Emerging markets data is available from MSCI starting in 1988. More than half the time, for the better part of 14 years, emerging markets did not keep pace with the MSCI EAFE, which was not keeping pace with the S&P 500. The second and third periods of underperformance are short because there isn’t much history in this asset class. I’ll speculate that over the next 50 years there will be several long periods of underperformance.
Getting paid to take investment risk can take time, a lot of time. If you don’t have a lot of time, then don’t take a lot of risk.
There is another piece to the risk puzzle that changes this equation somewhat. I’ve shown that each individual risky asset class can take decades to pay out. However, mixing several risky asset classes together in a portfolio can cut down on the time for the total portfolio risk to achieve a higher return.
As shown earlier, a portfolio holding 50 percent in 5-year T-notes and 50 percent in the S&P 500 earned about half the return of a 5-year T-note since 2000. In comparison, a Blend Portfolio of 50 percent in T-notes, 25 percent in the S&P 500, 10 percent in small value stocks, 10 percent in developed markets, and 5 percent in emerging markets surpassed T-notes during October 2006. Figure 2 illustrates this performance.
Figure 2: Diversified Portfolio Return of $1 (January 2000 – October 2011)
Granted, the Blend Portfolio is not earning more than T-notes yet, and it did fall more during the financial crisis in 2008, but it also recovered faster and to a higher level. It’s likely to outperform T-notes before the T-note/S&P 500-only portfolio. Diversifying among several asset classes with different types of risk tends to be a better alternative than concentrating on one risk from one asset class.
There are a few lessons to be learned from this study. First, risk takes time to pay off and waiting a decade or more is common. Manage your portfolio risk accordingly. Second, diversification takes advantage of low correlation among risk at times. This lowers the length of time it takes to earn an excess return. Third, in no case should your total risk be above your ability to handle losses, and that includes long periods of marginal underperformance.
Making money in the markets takes time and patience. Don’t become discouraged if an asset class misbehaves for several years. That’s perfectly normal. Stay disciplined, use low-cost index funds and if you need help, seek a low-cost advisor. Give your portfolio time to work and you’ll earn your fair share of market returns.