Stocks represent ownership in a company and provide the long-term growth an investment portfolio needs. When you invest in stocks, you invest in the growth of companies and the economy.
While bonds provide investors with stability and are more predictable, stocks have outperformed them for decades. Whether you invest in large companies or small ones, history shows that stocks will outpace bonds, as the above graph shows. Note, too, the difference between short and long-term bond investments. Over the last 90+ years, short-term bonds barely kept up with inflation, meaning investors who committed to short-term bond portfolios over the long term may have actually lost money over time. In fact, without stocks driving growth in a portfolio, even keeping up with inflation can be a challenge. We know that without stocks, an investment portfolio isn’t going to help you meet your goals.
Since owning an individual company’s stock ties your financial well-being to that company, you run the risk of losing lots of money.
In recent years, we’ve seen household names like Washington Mutual and Kodak go bankrupt, leaving their investors with worthless stock that’s eventually eliminated from the market. These stories can make people hesitate to invest in stocks at all. To make it even more nerve-wracking, the events most likely to significantly harm or help a company’s stock price often come as a complete surprise. And trying to predict which companies will have a good year has proven futile.
Luckily, the movement of one company’s stock is usually not exactly in tandem with the thousands of others. Bad news that hurts the stock price of one company is often good news that may help the stock price of another. While any individual stock may rise or fall dramatically, the movements of the entire market are generally more subdued. All of this leads us to build portfolios made up of mutual funds and exchange-traded funds (ETFs) that help us diversify your portfolio. These funds are made up of hundreds, or sometimes thousands, of individual stocks, giving you a small piece of many different pies. Holding a wide array of stocks within mutual funds or ETFs reduces the concentrated risk that comes from owning individual stocks. While a diversified portfolio is still subject to the overall movements of the market, the risk you take on with this type of portfolio is rewarded with big potential for growth. We fine-tune your specific exposure to risk through your mix of stocks and bonds.[i]
We discussed why we don’t invest in individual stocks in our portfolios here at Merriman. Below we discuss how we choose to build the diversified stock portfolio that provides more stability with large growth potential. Stocks are classified using a number of different criteria, including:
- Size: small vs. large capitalization – The total value of a company’s outstanding stock.
- Investment style: value vs. growth companies – Value companies are thought to be undervalued by the market. Growth companies show strong earnings growth figures.
- Profitability: high relative profitability vs. low relative profitability – How well a company is able to generate earnings compared to their costs.
- Market: U.S. vs. international – Where the company is headquartered.
The chart below shows how 10 different classes of stocks and bonds have performed over the past 20 years.[ii]
The chart shows why we diversify across asset classes, and is a good example of the randomness of returns among those asset classes. Note that it isn’t very common for an asset class to be a repeat winner year after year. That also means that the “losers” change every year. In 2007, emerging markets were the best performing asset class (and had been for five consecutive years). In 2008, emerging markets were the worst performing asset class, and then became the best performing asset class again in 2009.
We identify our target percentage for each asset class, defined by the criteria listed above. We don’t change that target based on what the market did last year, or what we guess the market will do next year. Just as with individual stocks, we don’t believe anyone can predict which asset classes will perform better in the short term. Merriman’s research team sets these target percentages, and they are constantly evaluating historical data and trends in order to build a portfolio that captures the long-term growth investors need.
The previous post in this series can be found here.
[i] “Compound Average Annual Returns: 1994-2016” Chart: Information provided by Dimensional Fund Advisors LP. The “All stocks” portfolio consists of all eligible stocks in Developed and Emerging Markets. The portfolio for January to December of year t includes stocks whose free float market capitalization as of December t-1 is greater than $10mln in developed markets and $50mln in emerging markets. The portfolios “Excluding the top 10%” and “Excluding the top 25%” are constructed similarly. Diversification does not eliminate the risk of market loss. Past performance is no guarantee of future results.
[ii] Data provided by Callan, an independent consulting firm. For more information, please visit www.callan.com.