Diversification- Taking Away the Guesswork, Jim Parker, Vice President, Dimensional Fund Advisers
With the negotiations dragging on, newspaper Barron's surveyed 10 strategists about equities' prospects for the coming year. The mean prediction for 2013 was for a price gain in the US benchmark S&P 500 index of about 10%.1 "This month's knotty negotiations among lawmakers over the so-called fiscal cliff…greatly complicate the job of forecasting next year's market returns," the newspaper said, quoting several analysts as dismissing hopes of a deal.
Across the Atlantic, an easing in Europe's sovereign debt crisis had spurred confidence in markets there, though there was still concern among analysts about whether the recent reversal in sentiment was sustainable. "Risks abound for next year", Reuters reported, citing turmoil in Italy, Spain, France and Greece and a looming general election in Germany. "The downside risks are less than they were, but they have not been removed."2
In Japan, the yen dropped to a 27-month low in December 2012 as a newly elected Prime Minister Shinzo Abe pledged drastic and aggressive action to revive a moribund economy which had been battling deflation for 15 years. Given the backdrop of the time, the hedging of bets and the prevarication among forecasters looked completely reasonable. There was a lot of risk around and it was difficult to forecast market returns with any sense of confidence.
So, what happened? The US Senate at New Year passed legislation to avert the fiscal cliff and attention turned back to the wider US economy. Europe stumbled on economically, but its equity markets stormed ahead. And Japan showed signs of responding to the Abe stimulus, sending its equity market dramatically higher. In fact, the US market was the top performing developed market in the world in 2013. The S&P 500's gain of just over 30% represented its best calendar year performance in 16 years and was three times the forecast of the Barron's survey. European markets were close behind, with Germany posting gains of a little over 30% in the year. Spain, which in late 2012 was pleading for money to bail out its banks, was the third best performing developed market in the world.
Even Japan, a market which had repeatedly disappointed investors over the years, staged an extraordinary rally to post its biggest annual rise since 1972, thanks in part to the stimulus efforts of the Abe government. At the other end, Australia, for so long deemed the miracle economy, was one of the laggards. While its gain of just over 20% was respectable, it nevertheless made it the second worst performing developed market after Singapore.
What are we to make of all this? Well, firstly, it seems evident that developing a reliable investment strategy on a forecast is extremely difficult. We have seen that even the most highly paid stock analysts struggle to get it right. What happens to be driving markets when they issue forecasts is not necessarily what will drive markets in the period ahead. Getting that right requires them to correctly anticipate the news AND guess how the markets will react to the news. Secondly, there is no real reason to be betting about which market will perform best in the coming year or longer. Concentrating your portfolio in one country or in one sector or one asset class just exposes you to unnecessary risk. And remember, a bet on one market at the expense of others not only means you are taking needless risk, it also means you may miss opportunities elsewhere. Thirdly, a strong economy does not necessarily imply strong share market gains going forward. When the news is bad, investors discount share prices to reflect what they perceive as the risks ahead. Lower prices relative to fundamentals just means those securities or markets are offering higher expected returns.
Finally, there is a way of taking out the guesswork so that you minimise unnecessary risk, maximise opportunity and smooth out the bumps along the way. It's called diversification. If you don't know which markets will perform best from year to year, you hold a globally diversified portfolio. By owning a little bit of many markets, you are ensuring you are in your seat when each market gets its turn at the top and you avoid the pain of having all your money staked on the one at the bottom.
This is the benefit of diversification. Chopping and changing and second guessing is a costly business. It's better to assume the market knows best.
And that way, no guesswork is required.
1. 'Outlook 2013', Barron's, 17 Dec 2012
2. 'Investors Bet on Euro Assets in 2013 Despite Risk', Reuters, 15 Dec 2012
