The two-year bear market has made a lot of investors wary of risk. Investors who thought nothing of buying the stock of a fledgling Internet company with no profits back in early 2000 are now slapping their money into bond mutual funds, certificates of deposit, and money market mutual funds. Despite low interest rates, money poured into bond mutual funds and money market funds last year. Investors pumped over $87 billion into bond funds in 2001, three times the amount they put into stock funds. A record $375 billion went into money market mutual funds, estimates the Investment Company Institute.
This is an understandable response to the plunge in world stock markets over two years, but it isn’t rational. Investors are compensated for taking risk. Those seeking “safety” in low-rate fixed income investments will receive less compensation for taking less risk.
The average investor has made at least two mistakes in two years: Back in early 2000 the average investor took too much risk and accepted the wrong kind of risk. Now, he is taking too little risk. Risk equals reward—that’s the mantra of long-term investors. Those who heeded this before the bear market believed it then but today they don’t. What went wrong? Many investors took the wrong kinds of risks, the kind for which investors are not rewarded. If investment research has shown anything over the last 40 years, it is that investors are not rewarded for taking risks that can be diversified away.
For instance, an investor who owns one or two stocks has taken on not only stock market risk, but also the particular risks associated with the companies that issue those stocks and with the industries in which those companies operate. Those risks could have been diversified away by buying stocks of different companies that operate in varied industries. A loss in an individual stock, or a slide in one industry, then would be offset by gains in other companies and other industries. The investor would still carry stock market risk and if the whole stock market declined the investor’s portfolio would decline. That decline, however, probably wouldn’t be as bad as the potential decline in an individual stock.
Now, I would like to shift gears and discuss international investing. It has long been argued that investing some money outside of the U.S. stock market will provide valuable diversification benefits. World stock markets don’t move in sync. Combining several international markets with that of the United States can reduce an investor’s volatility risk.
This has worked well since World War II, but not as well in recent years as the globalization of business has tended to synchronize world investment results. Large foreign stock markets in Europe and Asia have begun to move more in step with the U.S. market. In fact, the synchronization of the United States and major developed countries is higher than it was during the last period of close correlation back in the 1930s, a recent study by three Yale University professors found.
So where does else can an investor go to diversify? The answer may be to invest in stocks issued in developing countries in Latin America, Eastern Europe and Asia. Developing market stocks still offer a big diversification benefit, found the study by William N. Goetzmann, Linfeng Li, and K. Geert Rouwenhorst. “The benefits to international diversification have recently been driven by the existence of emerging capital markets—smaller markets on the margin of the world economy where the costs and risks of international investing are potentially high,” they write. Their study found that investing in the four major stock markets in the United States, France, Germany and the United Kingdom offers a 30% reduction in the volatility that would be experienced by investing in just one country. But a portfolio that included all of the world’s stock markets would reduce volatility by as much as 65%.
During the last half of the 1990s, emerging markets performed very poorly compared to the U.S. stock market. Over the last year they have done much better, outperforming U.S. stocks. Investors interested in emerging markets should use a mutual fund that spreads its assets over a variety of stock markets and stocks. Since there is no evidence that investors can select the best emerging markets, a passively managed fund that puts equal amounts of money into a number of emerging stock markets may be the best choice.
For those of you who are asset management clients, you will see that your stock position in emerging markets has performed quite well during the last year, while several other asset classes (such as U.S. large stocks) have done quite poorly. This was certainly not predicted by most of the popular market strategists a year ago! This is just one example of why I am committed to building and managing globally diversified portfolios using low cost, passively managed funds.
Now, I need to address some regulatory issues. In order to comply with the provisions of the Gramm-Leach-Bliley Act, I am enclosing a copy of KFP’s Privacy Statement for your review. The Privacy Act requires that I deliver this to every client on an annual basis. In addition, as a Registered Investment Advisor, Keystone Financial Planning is required by state and SEC regulators to offer you a copy of Form ADV. The Form ADV is KFP’s registration with the Pennsylvania Securities Commission. If you would like a copy of Form ADV, you may download it by going to the “Regulatory Compliance” page on KFP’s website (www.KeystoneFP.com). Please feel free to call me if you would like a copy of Form ADV mailed to you.
Finally, I want to take this opportunity to thank you for your trust and friendship. I feel very privileged to have the opportunity to provide financial planning and/or asset management services to you. Please let me know what I can do to improve the quality and value of my services.
About Christopher Jones
Christopher Jones is the Founder and President of Sparrow Wealth Management, a fee-only financial planning and investment management firm. Before entering the investment field, Chris was a management consultant for Deloitte Monitor. He graduated summa cum laude from Brigham Young University with a B.S. in Economics and a minor in Business Management.