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Part II: Responding to the Forecasts (Diversification)

| October 19, 2018
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As we promised on Monday, we are going to continue the conversation around current market conditions and portfolio construction through a short series of follow-on posts. Thank you to all who read and commented on last Monday’s piece. The one question that emerged most often was one regarding expected future returns. We presented a chart that showed expected 10-year forward returns, and this chart was admittedly gloomy in its forecast. A very astute person asked a simple question, “If expected returns are so low, how do we make money over the next 10 years?” I’m sure many of you thought that same thing. To that we say, “Great question!” – and now let’s explore the potential answer.

In our view, there are two answers to that question, and today we’ll look at the first (we’ll look at the second on Monday). That first answer is diversification. Keep in mind the original chart was based only on the S&P 500 (the largest 500 companies in the US). It didn’t make any reference to smaller companies (“small-cap”), European companies, or companies based in Emerging countries like Taiwan, China, or Korea. Typically over time different asset classes perform differently at certain times. That is one of the main premises for diversification. It’s called ‘correlation.’ Not all assets go up and down at the same time, or at the same magnitude.

Having different assets in your portfolio means two things. One, the minute you add a second asset class to your portfolio, you by definition will not have the “highest returning portfolio.” Two, because assets have different correlations to one another, diversification lowers the overall risk in the portfolio – and should lead to better outcomes over time.

There are cycles in every asset class and even between different asset classes. In the chart below (next page), you can see that there are periods of time that the US outperforms and periods that International companies outperform, just as there are cycles where “growth” stocks outperform “value” stocks and vice versa. These periods can be long in either direction. We have been in a period of US outperformance for the last 10 years and, if history is any guide, we would expect that cycle to change toward international companies outperforming over the next many years. You can see from the chart that the cycles last anywhere from 6-12 years, and interestingly enough you can see the peak we are currently at matches the last peak in the early 2000’s. Coincidence? Maybe. Or a sign that the cycle has run it’s course? We will see.

On Monday we will look at the second answer to that earlier question of how do we make money over the next 10 years given the gloomy forecast you saw this past Monday. Until then, we hope you have a great weekend – and as always, we invite your questions at any time.

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