Balancing Act: Managing Risk and Returns in Equity Portfolios

It’s no secret that over the last decade, the S&P 500 stock index has outperformed the other major asset classes. Did your equity portfolio fall somewhere in between? If it maintained a balanced blend of stocks across global markets, that's likely the case, and it's indicative of a successful outcome. Here's why.

The Standard & Poor’s 500 stock index represents ownership in the largest 500 publicly traded U.S. companies, which makes it hardly a wild speculation. In recent years, it has outperformed U.S. small company stocks as well as developed international and emerging markets stocks, each represented by a standard commercial index [1]. So, why haven't we invested more heavily in the S&P 500 and less in other asset classes, and why shouldn't we do so now? The answer lies in maintaining prudent and acceptable standards of risk management, which could safeguard against potential reductions in lifestyle spending in the future. There are five strategies for managing risk, two of which – diversification and hedging -- we will discuss here to address the question just posed. The other three (insurance, risk reduction, and reserves) will be addressed in future notes.

The Concept of Risk

Firstly, let's clarify the concept of risk within a wealth management context: it represents the likelihood of not meeting lifestyle spending goals. Equities should never be relied upon for short-term spending needs. Hence, our preferred measure of the risk in funding spending priorities with equities is the potential drop over ten-year periods. Among the four asset class indices we are considering, the S&P 500 has experienced the most significant drops over such periods. For instance, beginning in March 1999, the index witnessed two substantial drops over the next decade – 49% during the Dot.com crash and a subsequent 57% during the global financial crisis (GFC) – which together reduced an initial $1 million investment to only $710,000 ten years later (February 2009).

Risk Management Strategies

Diversification. Despite the above mentioned 10-year drop in the S&P 500, if we construct a basic balanced blend [2] of the four global asset class indices, akin to what we utilize at Quantum, the same $1 million investment would have been worth $1,020,000 at the end of the ten-year period. From 1999 to 2024, both approaches would have earned nearly identical average annual returns, just under 8%. In essence, one could have achieved the same return as the S&P 500 since 1999 while circumventing a significantly negative ten-year period – a rare instance of a free lunch in finance. And that's precisely what diversification aims to achieve.

Although the growth of the balanced global mix might not have been substantial over that challenging 10-year period, it certainly made it much less likely to arrive at the unfortunate and incorrect conclusion, as many did during that time, of abandoning their equity portfolio and missing crucial years of the market recovery post the GFC. This was a mistake from which many may never recover. For those relying on their portfolio during that time to fund their lifestyle spending, the balanced blend allowed many more investors to maintain their accustomed lifestyle without dangerously depleting their principle – the essence of risk management. It's worth noting that the balanced blend has its largest position, 50%, in the S&P 500 index, demonstrating how the diversification strategy enables significant exposure to the index while simultaneously managing risk.

Hedging. Much of the underperformance experienced with international stocks is a result of a strengthened U.S. dollar, rather than poor stock returns in local international currencies. Specifically, the cumulative return of international stocks in their local currencies have on average been very close to double their return expressed in U.S. dollars over the past ten years [3]. Consequently, over the same period, the cost of these foreign goods we desire and require has decreased due to the rising U.S. dollar, all other factors being equal. As a result, our true purchasing power hasn't worsened compared to if international stocks had outperformed the S&P 500 due to strong international currencies, with the cost of foreign goods rising in tandem. This epitomizes a "hedge", or what we term at Quantum "goal matching". With a hedge, you neither exceed nor fall short of your goal but merely match it.

What We’ve Learned

From a behavioral standpoint, reflecting on what performed best over a given period and suggesting in hindsight "we should have invested only in that" or "let's invest more in that going forward" overlooks the reality that at the outset of that period, it does not seem reasonable that we would have felt comfortable disregarding risk management principles. It's akin to admiring someone who struck it lucky and made a fortune in a game of Russian roulette and then pondering why we didn't, or worse, why we don't, do the same?

Moreover, from a valuation perspective, the more the S&P 500 ascends, the less likely it is to sustain continued high returns relative to other major asset classes. In essence, the other asset classes have been "saving" their higher returns for a future date, such that at this juncture, valuations suggest they have expected returns going forward 2-3% [4] higher than the S&P 500. Although those are only expectations, and valuation models are just that, models, it hardly seems reasonable to allocate more funds into an overly popular asset class at the expense of sound overlooked asset classes.

The Takeaway

Therefore, if your equity mix has been underperforming the S&P 500 stock index, it's likely by design, serving to mitigate the risk of experiencing unnecessary declines over long periods, such as a decade, while not sacrificing expected return over time.  Eventually, if history is any guide – and it is a pretty good one in investing – one of the other major asset classes will captivate our attention with soaring returns and we might be having this conversation all over again.

[1] These other three asset classes are represented here by the Russell 2000 Value index, Morgan Stanley Capital International (MSCI) World Ex USA index, and the MSCI Emerging Markets index, respectively. All index data herein is before any fees and taxes.

[2] The balanced blend is constructed of 50% S&P500 index, 15% Russell 2000 value index, 20% MSCI World ex USA Index (gross div.) and 15% MSCI Emerging Markets Index (gross div.)

[3] Avantis Investors Monthly Field Guide, March 2024

[4] Morningstar.com

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