By Dr. Jim Dahle, WCI Founder
I have seen a large number of forum discussions in the last year that basically consist of an investor expressing regret about an investment they own that has been “underperforming.” When you dive into the details, the investment is fine and the “underperformance” is only in comparison to US large growth stocks like the “Magnificent 7.” The investment being compared to those stocks, however, varies. I've heard essentially the same argument being used against broad market index funds, real estate, international stocks, small value stocks, and even bonds.
I thought it might be worth a few reminders today about why you own some of those other assets.
The Pendulum Swings
Just about every reasonable asset class will have its day in the sun. Investments are cyclical. US large growth stocks did great in the 1990s and then terrible in the 2000s. Then, they've been great again in the last decade or so. But they don't always do great. In fact, the best-performing investment asset in any given year is pretty variable. For quite a few years, Callan has been publishing a “Periodic Table of Investment Returns” that looks like this (click on the image to expand it):
You don't even need to know what the asset classes are. Just look at the colors. Notice how the colors at the top and the bottom are different every year. Consider emerging markets stocks, the orange color. It started out pretty awesome in 2004-2007, and then it went to the bottom of the chart. Then, back to the top. Then, all over the place. As I write this in late 2024, Vanguard's Emerging Market Index Fund shows 15-year returns of 4% per year. It's hard to get very excited about that despite it being just about the best thing to invest in for a few years before that 15-year period started.
The moral of the story? Maintain a diversified portfolio and don't chase performance.
The Case for a Total Market Index Fund
Index funds provide massive diversification, essentially for free. A US total market index fund may own 4,000 different stocks, including the Magnificent 7 stocks:
- Microsoft
- Amazon
- Meta
- Apple
- Alphabet
- Nvidia
- Tesla
In fact, the Mag 7 stocks make up about 25% of the US market by capitalization. But the index funds also own all the other stocks, so when the inevitable occurs and the Mag 7 underperforms for whatever reason, it won't break your heart. In the meantime, though, you might be a bit sad. An equal-weighted Mag 7 ETF (MAGS) is up 52.63% for the past year (as of early February 2025), while a total stock market fund is only up 22.35% in that same time frame.
More information here:
The 6 Stages of Diversification — Where Are You At?
Beware of False Diversification
The Case for Real Estate
With stocks up more than 25% in the past two years, you might wonder why you should bother with real estate? Publicly traded real estate is only up about 12% in the last 12 months as I write this, and private real estate may not even be that good with lots of projects still reeling from the 2022 interest rate hikes. Why do many of us invest in real estate? High long-term returns and lower correlation with stocks and bonds. But there's no guarantee those high returns are going to be there every year. And no, your crystal ball isn't functional enough to allow you to know exactly when to switch from real estate to stocks and back.
If you are interested in private real estate investing opportunities, start your due diligence with those who support The White Coat Investor site:
Featured Real Estate Partners
The Case for International Stocks
The US dollar has been strengthening for quite a few years. Add that to the Mag 7 boom, and people seem to suddenly recall that Jack Bogle didn't think investors need international stocks because US companies do so much business overseas. But currencies fluctuate, and so do the fortunes of US stocks vs. international stocks. In the chart above, the darker blues are the US stocks and the oranges are the international stocks.
International has really only won once in the last 12 years. Do you think that is going to continue forever and that the pendulum is never going to swing back? I'm not sure I'd bet that way. Valuations are terrible predictors of short-term returns, but they may be the best predictors of long-term returns. Near the end of 2024, per Morningstar, the Price to Earnings (P/E) ratio for international stocks was 14. It was 22 for US stocks and 35 for that Magnificent 7 ETF. Would you rather pay $14 for a dollar of earnings or $35? There's an awful lot of growth baked into that pricing. How much further do you think the Mag 7 has left to run? How clear is your crystal ball when you ask it about future currency fluctuations?
More information here:
Is Anybody Else Getting Nervous About an AI Bubble in the Stock Market?
Small Value Stocks
Factor investors have been taking it on the chin for a while. Pretty much my entire investing career so far. Small and value might still be ahead in the long run, but it's getting harder and harder to remember that each year. However, Larry Swedroe pointed out something in early 2024 that is worth a few minutes of thought. He pointed out that the valuation difference between large growth stocks and small value stocks is now at the same historical high it was before the dot.com bust. Check out his chart:
Trees don't grow to the sky, large doesn't outperform small forever, and growth doesn't outperform value forever. I have no idea WHEN we'll see a reversion to the mean, but it seems a massive mistake to me to abandon a small value tilt you've been holding for years right when the likelihood of reversion seems highest. Interestingly, international stocks are far more valuey than US stocks, so part of the US stock outperformance in the last decade may be more a growth/value story than a US/international story.
The Case for Bonds
I'm even seeing more and more people talking about dumping bonds in favor of a 100% stock portfolio, especially after the walloping bonds took in 2022 when interest rates rose 4% very rapidly. Bonds are a better investment now than they have been for years. If you liked them in 2021, you should really like them now. Bonds can and occasionally do outperform stocks for very long periods of time. They also reduce both mathematical and emotional volatility when included in a portfolio. A few people can tolerate a 100% stock portfolio during a global financial crisis or a global pandemic. But you'd better make sure you're one of them before you adopt that portfolio. And even so, eventually you've got to ask yourself if now that you've won the game, it is time to stop playing?
More information here:
The Nuts and Bolts of Investing
150 Portfolios Better Than Yours
Stay the Course
My portfolio includes index funds, real estate, international stocks, small value stocks, and bonds—just like it did 10 years ago. If I had put all my money in Mag 7 stocks (or, maybe better, Bitcoin) a decade ago, I'd theoretically be ahead. Except I probably never could have stayed the course over that time period. And even if I had, would that really be the right thing to do going forward for the next 10 or 20 years? Probably not.
You need to own a portfolio that is likely to do well in a large percentage of possible future outcomes. You need to own a portfolio you can stick with for the long term. Being diversified means always owning something you wish you didn't. But it's a good thing, not a bad thing. Stay the course. Jack Bogle said,
“Stay the course. No matter what happens, stick to your program. I've said stay the course a thousand times and I meant it every time. It is the most important single piece of investment wisdom I can give to you.”
While I was updating our investment spreadsheet the other day, Katie asked me, “When do we give up on these small value stocks?” I told her what the total of her investable assets was and asked, “Seems like the plan is working just fine to me, don't you think?” She had to agree that staying the course with our diversified portfolio over the last two decades was working just fine. I bet it will for you, too.
What do you think? Have you abandoned any of your diversifying investments? Why or why not?
First time commenter.
You are spot on, my man.
Have been doing this since I was a resident ( am done with the career and working 2x a month now)— IT WORKS.
Boring but effective and I sleep well at night!
Via email:
Great review for all investors. I couldn’t agree more.
Thanks for putting this together.
Via the forum:
Fabulous basic article. Stay the course. If you have a $5m portfolio and you look back and think “if only I hadn’t also included international in my AA or small value, I’d have even more” you are missing the forest through the trees. So you’d maybe have more. But you have $5m. What’s your plan to spend that money, and how would your plan be different if you had more than that?
Recent article from The Economist, “Why your portfolio is less diversified than you might think”, is worth a read. It makes the case that different asset classes are becoming more correlated, at least in part because they have become more accessible. I’d be curious to know your thoughts on the correlation between the major asset classes. If there is evidence to support a persistent trend toward more correlation, should that cause us to think a little differently about how to achieve true risk-mitigating diversification?
More correlated doesn’t mean perfectly correlated.
The Case for Bitcoin*
Thanks for this wonderful post.
I haven’t abandoned my diversifying investments, but the hardest ones to hold onto are the intermediate-term (5-7 year duration) bond funds. They have been down in value significantly since 2022. My broad market index stock funds came back a lot faster. It’s ironic because the intermediate term bond holdings were bought to de-risk the portfolio. I’m not selling the bond funds, but I can’t bring myself to buy more of them.
You can’t buy more of them because they’re cheaper to buy than they were in 2021? See the logical problem with that reasoning? Or are you worried that interest rates are going to go up 4% from here?
Great article Jim as always, and great reminder to stay the course. Have you met any investors though that in their written financial plan had outlined conditions where they would abandon a factor tilt? are there reasonable reasons to abandon ship and what are they?
No, haven’t seen that before. I do tell people “don’t tilt more than you believe” so I guess if you no longer believe the tilt will benefit your portfolio you should abandon it.
I’m actually an example of someone who fits that bill on having a tilt but also having written in when it would go away.
Specifically, I worked for one of the big tech companies, so added a somewhat significant small cap tilt to help derisk since such a large portion of my compensation was coming via stock (and I didn’t count non-vested stock as part of my portfolio, but arguably it added a tilt in the opposite direction).
I had two points in my plan to reduce that tilt – when I became financially independent (I essentially reduced tilt to only balance my s&p 500 holdings to be comparable to total stock, since I used it as the TLH partner for total stock), and when my compensation was no longer coming from big tech (remove tilt to simplify).
Thank you for sharing. You’re unique, of course, but so is everyone else.