Buggin out in 2014

Barry Ritholtz said something that really hit home. He eloquently stated, “In a diversified portfolio some asset classes will be lagging, and some leading; this is a feature not a bug.” With dividends reinvested and no fees, the S&P 500 returned over 13% in 2014. The portfolios I manage garnered less than half of that. Though I did not violate Warren Buffet’s two cardinal rules of investing: Don’t lose money and always refer to rule number one, this was a disappointing outcome. What the hell happened? In the words of James Osborne, “Diversification sucks!” 

Strike One – In 2014, a globally diversified portfolio returned about 2%; emerging markets lost 3% and developed foreign markets lost 7%. I am a firm believer in index funds and a smart passive investing strategy. I am first to admit, I have no idea what asset classes are going to outperform, so I buy lots of them to be safe. I don’t want to get on the bad side of Cullen Roche, so I try to create portfolios similar to world stock market capitalization. The U.S. represents less than 50% of all value, so to be true to my word, a hefty portion of clients’ assets is invested outside our borders. I may have had a sucky year but no one can accuse me of home country bias! This became an enormous drag on returns. A 50% allocation earning 11% in the U.S., combined with a 50% component losing 7% in foreign markets leads to a return of 2% for your equity allocation. We are all supposed to hate something in our portfolios but this is a bit much.

Strike Two – At the beginning of the year it seemed like foreign markets were cheaper than those in the U.S. I look at the CAPE ratio and follow Mebane Faber‘s stuff. I even included GVAL, an ETF that invests in the world’s cheapest markets in some portfolios, including my own. While I strongly believe this will work out in the long term and is well constructed, my brilliant allocation to these nations has led to double-digit losses in the short term. Cheap markets can get cheaper and expensive markets can get more expensive. Lesson learned. The good thing was I had a lot of tax loss material in the taxable accounts, which I replaced with similar funds to avoid the wash sale rule. In a year of massive suckdom, I will take what I can get.

Strike Three – I, along with pretty much everyone else, thought interest rates would rise this year. If you didn’t think that, you are either a liar or Jeff Gundlach. Therefore, I was terrified of long-term bonds, which rewarded my timidity with a return of 30%! Keeping duration short, and leaving cash available to take advantage of the predetermined spike in rates, left a return of about 0% for this asset class. Lesson learned, the consensus is always wrong.

So in order to have a tremendous year, an all-U.S. large-cap equity portfolio would have needed to be combined with a long-term U.S. bond fund plus a dash of REITS, which returned about 30%. Full disclosure, I am not a complete nincompoop and had a 5% allocation here. Looking back, I would I have never created such a portfolio. I can sleep comfortably knowing that I am not a victim of hindsight bias.

What to do going forward? Rush into large cap U.S. stocks, Long Term Treasuries and REITS like there is no tomorrow? Maybe I should jettison my most hated nemesis, emerging market ETFs and their partners in crime in Europe and Asia? All of the short-term bond funds and cash could be deployed into high duration funds to take advantage of the permanent collapse in interest rates. Maybe I should purchase triple leverage U.S. dollar funds to brilliantly play the trend that the dollar will continue to rocket skyward? After all, many commercials say foreign exchange trading is pretty easy (full disclosure: I was an FX trader; I can assure you, it is not). Allocating a huge portion of portfolios to the utility sector, which was the best performer in the S&P last year, cannot be done any sooner (though they are selling at historic nose-bleed valuations). Damn the torpedoes and full speed ahead! Should I make these moves on the opening bell January 2, 2015? In the words of LL Cool J,” I don’t think so!”

I have a strong belief that a globally diversified portfolio is man’s best chance in the turbulent and unpredictable world of investing. As Michael Blatnick has proven with brilliant research, most well-thought out strategies work if you stick with them. Falling victim to the “recency effect” will guarantee massive nonperformance proven by the behavior gap that afflicts the majority of individual investors. Market timing is impossible. As far as forecasts go, Ben Carlson sums it up perfectly with his quote, “Genius must be proven. “Looking at these alternatives, a globally diversified portfolio looks pretty good for the long term, warts and all. 

The markets will do what they will do and investing is not for the meek. Rick Ferri recently stated, “Opportunities outside the U.S. are at least as good inside.” I hope he is right. The old saying regarding investing still holds sway: If it feels good, you are probably doing something wrong. This too shall pass and mean reversion will eventually arrive. In the meantime, I cannot get the words from Run- D.M.C. out of my head, “‘Mary, Mary, why ya buggin?”