I played golf last weekend with a very special kind of money manager.
He handles the investment portfolio of only one client.
That’s right, one.
Needless to say, his client is highly affluent. And my pal the money manager is no dummy either.
He knows his client is not looking for economic forecasts, market timing advice or hot tips. He’s acutely interested in a single key element: the right asset allocation.
In my experience, sophisticated investors know that asset allocation is their single most important investment decision.
Unsophisticated investors, on the other hand, generally don’t even understand the concept.
“Yeah, yeah, I get asset allocation,” a relative told me recently. “It means diversify.”
You can own an S&P 500 index fund and be broadly diversified. After all, you’ll own a piece of 500 different companies.
This is certainly superior to rolling the dice with a couple of stocks.
But unless you think your ideal asset allocation is 100% U.S. large caps – and, incidentally, the U.S. market has not been the world’s best-performing market even a single year in the last 30 – that kind of diversification isn’t enough.
Asset allocation – responsible for as much as 90% of your long-term investment returns – refers to how you spread your risk among different asset classes.
There are a lot of them. In the equity department, you have large caps, midcaps and small caps. Growth stocks and value stocks. Foreign stocks and domestic stocks. And within the international category, you have developed markets and emerging markets, including Latin America, Eastern Europe and Southeast Asia.
In the fixed-income area, you have long-term and short-term bonds. Governments and corporates. High-yield and high-grade bonds. Tax-free and taxables. And let’s not overlook other income alternatives like real estate investment trusts (REITs) and Treasury Inflation-Protected Securities (TIPS).
I hate to be blunt, but if you don’t know your portfolio’s asset allocation – or you’ve never given the idea much thought – you really aren’t paying attention.
But back to my golf pal…
Like most experienced investors, his client wants an asset allocation that will deliver the best returns with the least risk. He isn’t looking for someone to recommend 60% U.S. stocks and 40% U.S. bonds. (Who the heck pays for that kind of plain vanilla advice?)
He’s taken advantage of the run-up in our domestic markets. Now he’s considering where the next outsized gains are likely to be.
And here, my friend and I agree: emerging markets.
Take a look at the chart below. It shows the performance of various asset classes over the last 14 years.
(Source: Novel Investor)
It also beautifully illustrates the value of asset allocation. Every asset class has its day in the sun… and its day in the cellar.
A quick glance shows you that REITs, for instance, have been on a tear over most of the last decade. But they are a laggard this year and may be for months or years to come. (Exactly what you’d expect after years of outperformance.)
And look at emerging market stocks since 2007. They plunged 53% in 2008, fell 18% in 2011 and dropped 15% in 2015. They also posted negative returns in 2013 and 2014.
To many investors, it seems like emerging market stocks – which have also had a mediocre performance this year – are a terrible investment.
Yet look further back. Emerging markets soared 40% in 2007, 33% in 2006, 35% in 2005, 26% in 2004 and 56% in 2003. In other words, when they move they really move.
And as recent history shows, they are overdue for a big upside move now.
This doesn’t mean that anyone should pile all or most of their equity money into emerging markets. But if you’re looking for a sector to overweight, this looks like a fine choice.
Don’t get me wrong. There is no guarantee that emerging markets will soar in 2017 or 2018. (And no guarantee that they won’t.)
But if you had to bet which equity class will outperform over the next three years – emerging markets or the U.S. market – take emerging markets.
What goes around eventually comes around.
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Source: Investment U