Academic research suggests that investors can realize greater investment returns over multiple business cycles when they allocate a portion of the investment portfolios in small and mid cap sized companies. Many investors place too great an emphasis on large cap stocks for their asset allocation models. By so doing, investors miss a significant portion of the universe of securities which represent investment opportunity while enhancing portfolio diversification and greater long-term gains. Based on a personalized investment policy statement you can determine the optimal mix of foreign and domestic, large, mid and small cap stocks based on your risk tolerance and investment time horizon to deliver predictable results.
Markets on the Move
A review of market index performance for the first half of 2015 can help provide insight. First, a review of various stock market indexes such as the S&P 500, Russell 2000 and MSCI EAFE Indexes are good proxies for the large cap, mid/small cap and foreign stock universe for investments. But before we continue what was the performance for these indexes in 2014? The performance statistics in 2014 for the S&P 500, Russell 2000 and MSCI EAFE Index performances was 13.69%, 4.89% and -4.90%, respectively. For those investors who concentrated the majority of their investment allocation in large cap stocks they might feel their convictions have been rewarded. How well would this work in first half of 2015?
The performance statistics by mid-2015 were quite different, for the S&P 500, Russell 2000 and MSCI EAFE Index performances through June 30, 2015, was 1.23%, 4.75% and -5.53%, respectively. So why the change in performance leadership and what are the implications for investors? Many investors have observed that the value of the U.S. Dollar has increased substantially relative to most foreign currencies over the past year. Factors contributing to this trend include economic weakness abroad, greater U.S. energy independence and the expected rise in U.S. interest rates relative to foreign governments. This trend is expected to continue and the implications for investments in U.S. stocks should be clearly understood. For the first half of 2015, many market watchers believe small and mid cap stocks have less exposure to foreign currency translation losses because most of their business is domestic whereas, large multi-national U.S. companies derive the majority of its revenues generated in countries with weaker currencies. Foreign stock also benefit from a stronger dollar because their products are less expensive for consumers resulting in stronger expected sales volume which drives the value of the foreign companies higher.
Asset Allocation at Work
How do asset allocation strategies work to help investors from chasing the hottest sector and getting “whipsawed” by buying high and selling low? It is important to understand that trying to predict future outcomes by looking at the recent past is the path most inexperienced investors pursue. Professional financial advisors are educated and trained by the fact that changes in market circumstances are random events which have understandable consequences that are still, nonetheless, unpredictable. So why is this realization so important? Because the construction of asset allocation models is designed to capture the potential investment returns available across all asset classes over time.
Conclusion
How should investors remain balanced through market cycles to capture investment returns, without losing your balance? Stay constant by first, checking your investment policy statement to make sure your goals and risk tolerances have not changed. Next, rebalance your portfolio allocations to comply with your asset allocation model which forces you to remain disciplined while risk remains more constant through changing times. If circumstances, attitudes or new perceptions have changed your investment objective, risk tolerance, or investment time horizon, these changes should be incorporated into the investment policy statement and in turn, the asset allocation model strategy.
