The Map to Investing: What it Does and Doesn’t Tell Us
Executive Summary
If you were to map how different asset classes have performed over the last 11 years, you would see that it’s a random walk towards higher prices. The top performers never stay at the top and the bottom performers never stay at the bottom. Over time, these fluctuations average out. As an investor, this map teaches 2 lessons: diversify and past performance is not an indicator of future performance.
How difficult is it to invest?
The answer: It depends
Investing can be as complicated or as simple as someone wants to make it. Results may vary, but there are general principles that even the most novice investor can implement.
What is the asset class map?
The asset class map is a year-by-year comparison of various asset classes since 2011. 2011 is the starting point because that was the first year of my data set. While it would be great to have a longer-term data set, this map will grow over the years and give a longer-term perspective after each passing year.
The map is a collection of various indexes that represent some but not all of the possible investable assets in the world. A stock market index is a collection of investable assets comprised of specific investments that meet select criteria. The general concept is one investment cannot accurately represent an entire class. Example: Walmart does not accurately represent how all large corporations are performing in a given year.
An index consists of hundreds or thousands of similar investments to understand how a class of investments has performed relative to others. These indexes measure performance quarterly, annually, and even beyond a decade of performance. It is not uncommon for an index to finish a quarter or year with a much different performance than it has performed over the life of the index. Indexes have a historical average annual gain or loss, and over a shorter term, the index can fluctuate wildly.
Indexes are tools to track performance for investors, but an index itself is not an investment. While investors cannot directly invest in an index, investments attempt to track and match an index. These are called index funds. Since it is an attempt to copy an index that changes, there is inevitably some difference in performance. Timing delays between when indexes change and when the index funds change contributes to the difference.
What is each asset class?
The asset class map has various squares representing an index and its performance. One of the terms you will see is "cap" which is short for capitalization. Capitalization calculates the size of a company based on its stock price and how many stocks are available to investors in the stock market. Small-cap companies have a total value between $300M and $2B. Large-cap companies have a value of more than $10B.
Indexes provide a broad view of most investable assets, but they do not represent every investment available to investors in the world. The indexes are as follows:
US Large Cap: S&P 500 - The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.
US Mid Cap: Russell Midcap Index - The Russell Midcap Index measures the performance of the 800 smallest companies in the Russell 1000 Index. It is the most widely used Midcap index for US companies.
US Small Cap: Russell 2000 Index - The Russell 2000 Index is a small-cap stock market index of the smallest 2,000 stocks in the Russell 3000 Index.
International: MSCI EAFE Index - The MSCI EAFE Index represents the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia, and the Far East, excluding the US and Canada.
Emerging Markets: MSCI Emerging Markets Index - The MSCI Emerging Markets Index reflects the performance of large-cap and medium-cap companies in 27 nations. All nations are considered emerging markets. Their economies or some sectors of their economies are rapidly expanding and engaging aggressively with global markets. Examples include China and India.
Home Real Estate: S&P/Case-Shiller US National Home Price Index - The S&P CoreLogic Case-Shiller US National Home Price NSA Index measures the change in the value of the US residential housing market by tracking the purchase prices of single-family homes. The index covers all homes across the US in urban, suburban, and rural communities. This index is on a 3-month lag, so these values are not the December 2021 final numbers. The annualized October 2021 numbers are in use until December numbers are released.
REIT: MSCI US REIT - The MSCI US REIT Index is an index comprised of equity Real Estate Investment Trusts (REITs). A REIT is a company that owns and, in most cases, operates income-producing real estate. REITs own many types of commercial real estate, including office and apartment buildings, warehouses, hospitals, shopping centers, hotels, and commercial forests.
Precious Metals: S&P GSCI Precious Metals - The S&P GSCI Precious Metals, Palladium & Platinum Equal-Weight provides investors with a reliable and publicly available benchmark for investment performance in the gold, palladium, platinum, and silver commodity markets.
Bonds: Barclays US Aggregate Bond Index - The index includes government Treasury securities, corporate bonds, mortgage-backed securities (MBS), asset-backed securities (ABS), and municipal bonds to simulate the universe of bonds in the market. Bonds are essentially a way of describing debt that investors can buy. Bonds pay a fixed interest rate to the purchasers of bonds until the borrower pays back the amount borrowed.
Timing of the Asset Class Map
The asset class map shows performance over both one-year periods and the average growth rate of each asset class as of 2011. 2011 is the start of the asset class map. These asset classes have existed for much longer than the last 11 years, but the data for the map only exists starting in 2011.
Stock markets have existed for centuries. The asset class map does not show the entire historical performance of each asset class. Instead, it shows the change in performance over time in both a short-term and longer-term view.
What the asset class map tells us
The asset class map is not for making investing decisions. It is a visual representation of how asset classes interact and change over time. There are lessons to learn from the map, but, which investments to choose, is not one of them. Some lessons are:
Past performance does not indicate future performance.
Take a look at the asset class map. How many times did an asset class have an identical investment performance from one year to the next?
Not once.
Next, look at the map and see all the assets that performed the best in a given year. How many instances were those assets the best performing asset class the following year?
Zero times.
Now, look at the bottom of the map and see the worst-performing asset classes. How many asset classes stayed as the worst-performing asset class from year to year?
Zero times.
The asset map makes it clear to see: Past performance does not indicate future performance.
A mistake people make is investing in investments that were top performers from the year before. People will invest in those investments assuming the outperformance will continue. Not only does that usually not happen, but they often miss future investment opportunities that outperform the former best investment.
If an investor is going to look at performance metrics, it is better to look at the long-term performance (10+ years) over short-term performance (0-3 years). The longer-term view removes some, but not all, of the volatility from short-term price movements. It also provides a better understanding of the long-term trend of an asset class.
But remember that even long-term performance does not indicate how an asset class will do in the future.
Diversification is important
Take a look at the map, and you can see that over the years, asset classes can be the best-performing asset, the worst-performing asset class, and everywhere in between. Investing in just one asset class will leave an investor subject to the performance of that single asset class. Some years that investor will look like a genius. Other times they might underperform every other asset class.
As shown in the map, historically, assets have increased in value. By diversifying, investors capture all asset class gains (and losses), but still have a better chance of increasing the value of their portfolio over time.
The asset class-map demonstrates the benefits of diversification. By owning all or multiple asset classes, an investor has a better chance of investing in a top-performing asset class. This high-performing asset class may offset the other asset classes that underperform in a given year.
Take, for example, Bonds compared to the US Large Cap asset class. In years where the US Large Cap asset class underperforms, like in 2015, bonds had a high-performing year. Historically, bonds have a low correlation to stocks, meaning that as stocks perform well, the bond asset class does not perform as well and vice versa. By adding bonds, they act as a buffer against stock underperformance. In the good years, they might reduce the total gains, but in bad years, bonds may offset some of the losses.
Why is that important?
There are two portfolios: one with all stocks and one with stocks and bonds. In a given year, stocks decrease by 50%. The portfolio with stocks and bonds drops by 33% due to the bond gains offsetting some losses. As the stock market recovers, the all-stock portfolio needs to see a 100% gain to get back to its starting amount. Meanwhile, the portfolio with stocks and bonds needs a 50% gain to get back to its starting amount. The sooner an investment can get back to its starting amount, the sooner it can continue to grow in value.
Diversification helps by offsetting losses and benefitting from random out performances.
Over the short term, performance is volatile.
Volatility means that values fluctuate from the historical average of an asset class. In shorter times of less than a year, an asset class can significantly differ from the historical average.
Looking at Emerging Markets over the last 11 years, the asset class averaged a 3% annual gain. Yet in 2011, Emerging Markets lost roughly 18%, and in 2017, Emerging Markets increased by over 37%.
The short-term performance may influence an investor to sell after 2011 (assuming losses will continue) and buy after 2017 (assuming outperformance will continue). As shown above, past performance does not indicate future performance. Not understanding this may cause an investor to sell at the bottom and buy at the top. Not an ideal investing strategy.
It is impossible to predict the future performance of an asset class with a high degree of certainty. Life is just too uncertain, and stock markets are too complex. For young investors who will invest over 50+ years, short-term volatility should not change an investing strategy because it is often not reflective of the long-term performance of the asset class.
What the asset class map does not tell us
There is plenty to learn from the asset class map, but it is not a guide to investing in the stock market. Trying to discover patterns or investing strategies based on past performance is not a proven strategy for success. The human mind tries to identify patterns, even when, in reality, they do not exist. It is natural for people to look at the asset class map and develop a strategy to get the most of their investments.
Once again, past performance does not indicate future performance.
Also, the asset class map represents a short time frame. All asset class performance data is from after the post-2008 financial crisis. Except for the brief COVID decline, the asset classes in the map do not have any data to show what might happen in a recession or worse.
Some other lessons to learn are:
There is no way to see how to invest for YOU.
The performance data offers some investing insights. In general, the map shows that diversification can offset losses and spread around our chances to capture gains, but how much should someone invest into each asset class?
The US market has outperformed over the last 11 years but will it continue to beat the other asset classes over the next 11 years? It is impossible to know for sure.
Is it wise for a person retiring in one year to have their entire retirement savings in the same investment portfolio as a young lawyer who began investing one year ago?
Probably not. The young lawyer can be riskier in their investments because they are pursuing investment growth, so they can be riskier in their investments. The person near retirement needs to be more cautious because a significant drop in their portfolio tomorrow can affect their lifestyle throughout retirement.
Everyone has a different comfort with taking risks. This comfort with risk is known as risk tolerance. Investors with diverse risk tolerance profiles would benefit from various combinations of these asset classes. The asset class map does not identify risk tolerance, nor does it show what an investment portfolio should look like given certain risk tolerance.
The asset class map is a great tool, but it is not the foundation of an investment plan. It is merely a visual representation of the dangers and opportunities an investor may experience over the life of their investments.
What will performance be in the future?
Here is a challenge for any lawyer who looks at the asset class map and thinks they have a better idea of how asset classes will perform in the future.
E-mail your predictions to me for how each asset class will rank at the end of 2022. You do not have to guess the percentage gains or losses of the asset classes, but try to predict the order of their performance correctly. I will give anyone who predicts them correctly a prize.
If you would like a more difficult challenge, send me a prediction for the rankings of the annual averages at 15 years.
The world is unpredictable. Over a year or multiple years, the future is impossible to predict. Who in 2018 would have guessed a worldwide pandemic that would disrupt supply chains, shut down countries, and change the way we work? The COVID pandemic is just one of many unexpected events that affect the course of history. It is safe to assume another unlikely but highly impactful event will happen in the future.
We cannot be sure what the event will be and when it will happen, but we can prepare ourselves as much as possible. The asset class map cannot tell us where to invest and how asset classes will do in the future, but it can teach us to diversify and take a long-term view of investing. Implementing these few key lessons can help any investor over their investing life.
Investing effectively is a top concern for many young lawyers. Investing incorrectly can set back an investor in terms of future financial freedom. Investing correctly can help a lawyer achieve financial freedom. Developing Financial includes investment management as part of our ongoing financial planning service. If you are interested in learning more about how to invest as a young lawyer and the benefits of investing effectively, schedule a free Meet & Confer. Together we can set up an investment plan, implement the recommendations, and monitor the performance going forward. Investing doesn’t have to be difficult or scary. Let a financial planning professional help you today!
Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.