Diversification – Not feeling that great?

As we enter 2016, the U.S. equity market (as measured by the Russell 3000^® Index) is coming off a strong 5-year run. Returns haven’t been 1990s tech bubble level, but the gap between U.S. equities and non-U.S. stocks (represented by the MSCI EAFE Index) and bonds (represented by the Bloomberg U.S. Aggregate Bond Index) are among the widest we’ve seen in 40 years. The late-‘90s tech bubble environment was the only other period that has reflected similar U.S. stock dominance.

Experiences like these often create the temptation for investors to abandon portfolio diversification and chase the “winning” asset class. This temptation becomes particularly difficult for U.S. investors when the U.S. equity market leads others, and results in two powerful forces possibly affecting investors’ behavior:

• Recency bias: The human inclination to use a recent experience as the baseline for future expectations.

• Home country bias: the tendency to allocate a greater portion of one’s portfolio to assets domiciled in your home country

Individually, each of these biases can lead to poor decisions that hinder financial outcomes. Taken together, they have the potential to derail even the best laid plans.

Are investors at risk of falling victim to these destructive behaviors today?

To understand why investors may be especially prone to falling prey to this destructive behavior today, we put recent results into historical context. In Exhibit 1 we:

• Calculated 5-year returns for U.S. stocks, non-U.S. stocks, and bonds ending December 31, 2015
• Calculated U.S. stocks’ excess return for those 5 years
• Made the same calculations for rolling 5-year periods over the 40-year time horizon ending December 31, 2015 in order to compare the current relationship to historical results

Sources: U.S. Stocks: Russell 3000® Index, Non-U.S. Stocks: MSCI EAFE Index, Bonds: Bloomberg U.S. Aggregate Bond Index. The 5-year results ending December 2015 demonstrates a U.S. equity excess performance of

• 8.1% annualized versus non-U.S. stocks
• 8.9% annualized versus bonds

This excess performance is very strong relative to the 40-year history – which stood at -0.1% on average versus non-U.S. stocks and +2.9% versus bonds. Focusing on the most recent 5-year return period, we observed that the U.S. equity excess return relative to non-U.S. stocks exceeded 80% of historical outcomes; and exceeded 82% of historical outcomes relative to bonds.

These results appear even more one-sided when combining the U.S. equity results relative to both asset classes for the 5 years ending in 2015. In that scenario, the total excess return (8.1% + 8.9% = 17.0%) exceeded 85% of the previous 5-year period comparisons. The only 5-year stretches in which U.S. stocks exhibited greater dominance was early in the current U.S. rally, and periods encompassing the dotcom bubble.

So, it’s easy to understand why investors may be tempted to succumb to the twin biases of recency and home country: 5 years is a long time for investors to endure historical “underperformance” from the portfolio’s primary diversifiers.

Penalty for succumbing

However, investors who do give into temptation risk getting whip-sawed by the markets. Market leadership doesn’t last forever and it can swing the other way very quickly, often without warning. We must only flashback to the late ‘90s to see the excessive results of the U.S. equity market and the comparatively uninspiring returns of non-U.S. equity and bond markets. Unfortunately, those who abandoned their diversifiers to chase U.S. equity riches were not rewarded at the turn of the century. Sources: U.S. Stocks: Russell 3000® Index, Non-U.S. Stocks: MSCI EAFE Index, Bonds: Bloomberg U.S. Aggregate Bond Index.