Tapestry
2022 is in the rearview — it was a difficult year for investors, but with the turn of the calendar comes an opportunity to reset.
As David Booth, Chairman and Founder of Dimensional Fund Advisors, put it:
“One of the best things about markets is that they don’t have memories. They don’t remember what happened last week or last year. They don’t even remember what happened a minute ago. Prices change based on what’s happening right now and what people think will happen in the future.
People have memories. Markets don’t. And that’s a good thing.”
Well said.
(Here’s Booth’s whole article if you’re interested)
But also, what does a year really mean within the context of your life? We need a longer view.
Let’s look at last year within the context of the 2000-2022 period. Below is our Asset Class Tapestry which does just that.
Here’s how to read it (you can click on the image to get a bigger view):
- Asset classes for each year are sorted with the best performers at the top and the worst at the bottom.
- The two columns at the far right show the simple average return (arithmetic) and the compounded average of each asset class from 2000-2022. More on how these are different below.
- For a simple analysis, just pick a color and track it along for the last 23 years. How often was it on top? How often on bottom? Considering the variability of returns over a longer period is important when building your strategy.
(I keep a copy of this in my office for easy reference. If you want one too let us know. )
Here is what stands out to me about last year and the entire time frame (2000-2022):
- Commodities led the way last year for the first time since 2002 and only the third time since 2000.
- Large Growth stocks fell to the bottom performing asset class for the first time since the Tech Bubble. This will tend to happen when borrowing gets expensive (due to higher interest rates) and companies don’t have the earnings necessary to fund growth.
- High yield fixed income has outperformed the broad US bond market in 15 of the last 22 years, with 3 of those 7 underperforming years occurring during the 2000-2002 Tech collapse.
- The best investments last year, Commodities and Cash, would have been the worst to invest in for the last 23 years, cumulatively.
- Over the last 23 years, Emerging Market stocks have posted the highest simple (arithmetic) average return, but the 7th best compounded (geometric) return. Why? Because volatility matters.
Let’s address that last one for a minute, it highlights an important principle called Variance Drain (or volatility drag, depending on which Investing Nerd clique you’re a part of). Variance drain is best illustrated by this simple example:
- Investment A has a return in year 1 of 100%. and a return in year 2 of -50%.
The average return of this investment could be calculated two different ways:
Arithmetic Return = (Year 1 + Year 2) / Number of Years = (100% - 50%) / 2 = 25% average return
Geometric Return = a $1 investment at the beginning of year 1 grows by 100% and becomes $2. Then the $2 investment sees a 50% loss in year 2 and becomes $1. The starting and ending value are unchanged at $1, so the average rate of return is 0%.
The more volatile an investment is, the wider this gap between arithmetic and geometric returns. This is why we try to reduce the ups and downs within a strategy — the combination of yearly returns over time is what matters more than being in the “best thing” in any given year.
When I look at the tapestry above, I notice one thing above perhaps anything else:
The two best performing asset classes based on cumulative returns (the far right column) were Small Cap US Equity and US Large Cap Value Stocks. To anyone who follows the Fama French 3 Factor Model this wouldn’t be a surprise, but to everyone else it might be a shock to see that US Large Cap Value stocks posted the second highest 23 year cumulative return despite never being the best performing asset class in any given single year and falling far behind US Large Growth stocks for most of the last decade and a half.
When investing you have to play your own game, stick to your desired strategy, and put your blinders on from time to time so you’re not enticed by whatever thing is hungry for your attention (things like: crypto, Indexed Universal Life insurance, Gamestop stock, NFTs, high leverage real estate flipping, etc.).
Again, the best performing thing in any given year is not often likely to be the best performing thing over a longer combination of years.
With all of that said, here’s your homework assignment for this week:
1) Investors will often rush into things that did well in the recent past rather than what they think will do well in the future. Review what you currently own and ask yourself if your strategy is too reliant on what’s done well recently.
2) Look at the chart above and try to guess which asset classes will do best and worst in 2023. Email your predictions here and we’ll review it at this time next year.
Lastly, another quote from David Booth from the above referenced article:
”It can feel daunting to develop an investment plan you can stick with and determine the level of risk that’s right for you. But few things are more important than how you invest your life savings. That’s why most people would probably benefit from a financial advisor to help them talk it all out.”
If all of this kind of makes your head want to explode, I get it. This is why our clients have us to help decide on these things.
That’s all for today.
Onward,
Adam Harding
CFP | Advisor | Smartvestor Pro | Tapestry Maker
www.hardingwealth.com
*For informational purposes only. You cannot invest directly in an index. All returns referenced do not highlight any actual investor or portfolio, they’re to help illustrate a point.
