At the risk of sounding like a broken record—again—we join countless others in deeming that broad asset class diversification—particularly within stocks—is always prudent. With that said, we recognize that there are some years when diversification beyond the S&P 500 (i.e., large-capitalization domestic stocks) seems smarter than it does in others. But, as we write this, it looks like 2014 will not be one of those years. This is because, unlike in recent years, large-cap domestic stocks have thus far collectively outperformed U.S. mid- and small-cap stocks; furthermore, international stocks have lagged most of their domestic counterparts.
However, to reinforce the strong case for continually diversifying across markets, we attach two pieces. The first is a 10 Year Periodic Table of Asset Class Returns, the format of which you may be familiar with, as it is similar to another chart we’ve shared in the past. Please note the data in the chart are through September 30, 2014.
As you can see, while “Large Cap Core” (i.e., the S&P 500 index, represented by the deep blue boxes) has been the top performer year-to-date, at least relative to the four other broad stock categories included in the chart, there has been only one full calendar year over the past 10 in which it ranked first (2011).1 Moreover, when annualized over the entire 10-year period, large-capitalization stocks still had lower returns than mid- and small-cap U.S. stocks, as well as emerging market stocks. Thus, those who diversified beyond the S&P 500, as we have long advised, have generally benefited over this longer time horizon.
Notably, international stocks, particularly those in developed markets (represented by the purple boxes) have been relative laggards over the past several years, so you may be wondering why we have continued to advocate exposure outside the United States. To support our rationale, we enclose an additional chart, from Vanguard. More current data (Vanguard’s is through December 2013) would continue to show that nearly half the world’s total stock market capitalization is represented by companies domiciled outside of the United States, presenting a significant opportunity to maximize one’s diversification and investment universe. While a U.S. “home bias” still seems warranted for most U.S. dollar-based investors, we generally seek to allocate roughly a quarter of our clients’ stock exposure to diversified, low-cost international index/passive asset class funds. Indeed, our allocation is deliberately predicated on Vanguard’s research, which suggests that an allocation to foreign equities of between 20% and 40% is optimal from a diversification standpoint.
In sum, while large-cap stocks could repeat their top performance in the year(s) ahead, thus continuing to make diversification look “less smart” in the interim, no one knows for sure whether that will happen. Even Burton Malkiel, the octogenarian investment luminary and author of the highly acclaimed classic A Random Walk Down Wall Street, asserted in a recent Bloomberg article, “There isn’t anybody who can tell you what’s the best asset class for 2015. Nobody. I’ve never known anybody who knows anybody who can consistently time the market.”2 Our key takeaway: You should expect each year’s asset class winners to be different, and invest accordingly.
Speaking of surprises, let’s turn our attention to the bond market. With the Federal Reserve tapering off its quantitative easing bond-purchasing program, many Wall Street strategists entered 2014 expecting the yield on the benchmark 10-year U.S. Treasury note to rise from the 3% level it had reached at the beginning of the year. Instead, it has declined, and as we write this, it is just over 2%. This serves as yet another warning of the futility of betting on interest rate moves, just as we advise against betting on the near-term direction of the market and particular asset classes. History has shown that just because yields are low doesn’t mean they have to move higher; furthermore, even if an increase may be in store, we don’t know when, in what magnitude, and, importantly, how much of it is already factored into consensus market expectations (as reflected by the so-called forward Treasury yield curve). We also would caution you that there are a multitude of factors – both here and abroad – that can drive U.S. interest rates; indeed the current demand for U.S. Treasuries, which has pushed down yields, is being driven in part by even lower yields in several key foreign bond markets, notably in the Eurozone and Japan.
One consolation worth repeating, though, is that when interest rates do rise, so do bond yields. Therefore, while a bond fund may incur an initial price decline, it should be offset over time as bonds mature in the fund and are reinvested at higher yields. And the same holds for a ladder of individual, high-quality bonds: As bonds mature, proceeds can be reinvested at a higher rate. Therefore, all else being equal, increasing interest rates should result in a higher total return for longer-term buy-and-hold investors who stay the course.
As we head into 2015, here is our usual list of some general financial planning items to consider:
- The maximum federal tax rate on qualified dividends and long-term capital gains remains 20%, but only for taxpayers who are in the 39.6% marginal income tax bracket. Investors below those thresholds will continue to pay a maximum 15% rate on qualified dividends and long-term capital gains. However, these figures do not include the 3.8% Medicare tax on so-called unearned income for singles earning more than $200,000 and couples earning in excess of $250,000, as mandated under the Affordable Care Act.
- Maximum IRA contributions remain $5,500 for those younger than 50 and $6,500 for those aged 50 and up.
- Eligibility income ceilings for Roth IRA contributions increase, with contributions phasing out at adjusted gross income thresholds of $183,000 to $193,000 for couples and $116,000 to $131,000 for singles.
- The annual contribution limit for 401(k), 403(b), and 457 plans increases to $18,000 for those younger than 50 and $24,000 for those aged 50 and up.
- The limit on defined-contribution plans (Keogh profit sharing and SEP-IRA) increases to $53,000.
- The estate, lifetime gift, and generation-skipping tax exclusions, which are currently uniform and indexed annually to inflation, increase from $5.34 million to $5.43 million per person. The top tax rate remains 40%.
- The annual gift tax exclusion amount remains $14,000 per recipient.
Of course, no one has a crystal ball, but we can offer one guarantee for 2015: We’ll continue our steady focus on things we can control on your behalf—namely, helping you uphold clear, appropriate investment/financial objectives and a suitable asset allocation (as outlined in your Investment Policy Statement), diversify extensively, minimize all-in costs, and maintain perspective and discipline. Regardless of what the world and the capital markets deliver—in any given year—these remain among the essential ingredients to give you the best chance of financial success.
Thank you for the trust you continue to place in us. We wish you and your loved ones peace and happiness in 2015.
1. “Large Cap Core” has continued its top relative performance as of the date of this correspondence, December 19, 2014. The year-to-date total returns for the indexes, in descending rank order, are: “Large Cap Core” (S&P 500) +14.28%, “Mid Cap” (Russell Midcap) +13.19%, “Sm Cap” (Russell 2000) +4.05%, “MSCI EM” (MSCI Emerging Markets) +1.03%, “Int’l” (MSCI EAFE Developed Markets) +.0.84. Source: BlackRock.
2. Ben Steverman, “Burt Malkiel: Walk Away from 2015 Know-It-Alls,” Bloomberg News, December 10, 2014.