The Case Against 100% US Stock Indexing

liberty

Why not buy a US market cap weighted index and forget about it?

In my post on gold, I catalogued all of my disagreements with the perma-bears. In this post, I am going to talk about my disagreements with the perma-bulls who advocate owning nearly 100% US stock market cap weighted indexes.

100% US stocks is the preferred asset allocation of most FIRE bloggers. It’s the mantra repeated often in the financial independence blogosphere. Warren Buffett recommends a similar allocation, 90% US stocks and 10% treasuries.

I don’t think this is the optimal approach. I think investors should embrace stabilizing asset classes, global diversification, and moving away from market cap weighting.

USA: The Place to Be

I love the United States of America. I don’t find Lee Greenwood cheesy. I particularly love small towns in America. The traditional town square, modest homes with an America flag flapping in the breeze, the churches, the little communities. I listen to Ronald Reagan’s “shining city on a hill” speech and I find it inspiring.

Perhaps my perception is a fantasy about a world that doesn’t really exist anymore. Perhaps I’ve had pro-America propaganda fed into my brain since birth. Whatever.

Perhaps I’m blinded by patriotism and have been indoctrinated, but I think there is more to it than that. I don’t think it’s an accident that the United States became the world’s top superpower in the 20th century. I don’t think it’s just because of abundant natural resources and two oceans protecting us from invasion.

The United States has one of the best economic systems in the world. Our founders crafted a document that created a framework which was pretty hard to screw up. It has a number of safeguards built into it that maintain a certain economic and political framework that is very hard to untangle.

The testament to that framework is the results. There isn’t any country on Earth with standards of living that are as high and widespread as ours. The US ranks 10th in per capita income throughout the world, but that’s across 327 million people. Countries with higher levels of per capita income (like Switzerland, Luxembourg, Qatar), have much smaller populations.

For all of the complaining about our very legitimate problems, this is still the best place on Earth. Unequal distribution of wealth? At least we have wealth to distribute. Keep in mind that an income of $32,400 – a very average income in the United States – places a person in the top 1% of incomes globally. An average American lives better than 99% of the human beings on Earth. Keep in mind that half of the planet lives on less than $5.50 per day.

We have it pretty good, problems aside. Not only that, but for all of the whining about our infrastructure, it’s some of the finest in the world. When was the last time you had to drive on a dirt road? Or pay off a police officer because the country is completely corrupt?

The magnificence of this country seems entirely lost in our political conversation. We tend to dwell on our problems, rather than our strengths and how good we have it.

The Extraordinary Performance of US Markets

The long term performance of our capital markets reflects the soundness of the American economic model. Since 1871, the US has delivered a 9.07% nominal return, 6.87% real. There isn’t a country that comes close over a long enough time frame.

Since 1970, US stocks have crushed it. US stocks have delivered a 10.57% real return since 1970, or 6.41% real. The rest of the world delivered a 8.65% return, or 4.65% real.

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Since 2010, international investing has been an outright disaster. US stocks delivered a real return of 11.49% and the rest of the world delivered 3.32%. For perspective, the US bond market has returned 3.68% since 2010. This decade, you would have been better off buying a total bond market fund instead of buying international stocks.

2010

The US is indeed a wonderful economy. US investors never had to worry about the markets going to zero, which happened to other countries in the 20th century. Corporate governance is also strong. While there are the occasional frauds, we can reliably believe that companies will stay on the up and up. Those who stray will be prosecuted. The SEC will limit most, but not all, frauds.

We also have the largest military in the world, which helps play a role in protecting the interests of US markets. There is something to be said for having fleets of aircraft carriers, drones, and nuclear weapons looking out for our interests.

A US stock investor is investing in the best performing stock market in the world. Not only that, but they’re investing in some of the best and most profitable companies in the world. Berkshire Hathaway. Google. Amazon.

The US is also diversified, with representation in every economic sector and industry. This compares favorably to other countries, which are often concentrated in a single industry or sector. Take Australia, for instance, which is concentrated in financials and natural resources.

Meanwhile, compared to alternative asset classes, like bonds, US stocks have dramatically outperformed.

bonds

An investor looking at all of this data comes to a simple conclusion: why own anything else besides US stocks? They outperform every other asset class and they outperform the rest of the world. There are clear reasons behind this. There is an equity risk premium, a theory which postulates that US stocks outperform because they’re more volatile. Meanwhile, there are plenty of political reasons to think that the US stock market will continue to outperform.

A US index investor invests in all of the publicly traded companies in the country. Some will be extraordinary winners, some will be extraordinary losers. A 100% US index investor can also expect to pay low fees, and fees can be a massive drag on returns.

Buy an index fund and you’ll own your own piece of corporate America, which is always working overtime to deliver a return for you, the shareholder. There are ups and downs, but the market always recovers.

So, why not simply invest in 100% US stocks and call it a day?

Going International

While international stocks haven’t performed as well as US stocks, they can help an investor smooth out their returns during periods of time when US stocks are doing poorly.

I think this is due primarily to the unique relationship between the US dollar and the performance of the US stock market. US dollar strength tends to coincide with strong periods for US stocks.

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Notice the periods of time when USD is strengthening vs. other currencies: the late ’90s, the mid ’80s, the 2010’s. They’re all periods of time when US stocks are doing awesome.

Notice the periods of time when the dollar was weakening: the 1970’s, the 2000’s, the late ’80s. These were all periods of time when international stocks outperformed US stocks. Currency movements are a big part of this out-performance. It’s the interaction of the dollar with global currencies that provides an important diversification benefit.

This is best revealed when looking at returns from a decade-by-decade perspective.

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As you can see, international stocks tend to outperform during bad decades for US stocks. I might be wrong about my thesis about this (that it is related to currency movements), but the facts remain. International stocks can help even out returns and provide a more consistent return.

Political Risk: Millennials, The Allure of Socialism, & Political Diversification

I think international stocks also provide protection against the US embracing bad political policies. While the Constitution is strong and prevents politicians (and voters) from screwing up a good thing, it isn’t guaranteed.

Consider that 70% of Millennials say they’d vote for a socialist. Granted, this is a survey and the results are suspect,  but it largely jives with my conversations with people of my age cohort and younger.

The reality is that socialism is a guaranteed disaster and fails everywhere it’s tried in the world.

I suspect that Millennials aren’t really socialists. They are largely blinded because they have been surrounded by the fruits of capitalism their entire lives and take it for granted. It’s like the way a fish views water: it’s just the way things are. It’s hard for a fish to imagine being taken to the surface and drowning. Fully stocked grocery stores, utilities that work, a persistently growing economy, persistently improving consumer technology. That’s just the way life is from their perspective. The reality is that it is the fruit of our economic system.

With that said, I understand where Millennial socialists are coming from.

I suspect that Millennials really want to move away from a boom and bust economy. I graduated from grad school in 2006 and experienced sheer terror in 2008. I worked for a bank and was worried it was going under.

I watched people all around me pack up boxes and wonder for their future. Many of them were older and had a lot of debt. A bulk of their income went to their mortgages, as a lifetime of lifestyle creep bit them in the behind.

I was lucky enough to keep my job, but the experience shook me to the core. At the time, I was working 60-70 hours a week with no overtime. I wasn’t working like that to become the CEO of the company. I was working that way to ensure I’d stay off the lay off list because I knew that there weren’t any other jobs for the taking.

The whole experience lit a fire under me. Get the hell out of debt. Develop a bullet proof savings war chest in case I ever lose my job. I never wanted to experience that kind of desperation ever again.

Meanwhile, other Millennials graduated into that economy facing similar prospects. Many of them were in a worse situation due to student loan debt. I was lucky enough to get through college with academic scholarships, but I still had debt at the time and felt similar levels of desperation.

Facing that kind of economy in debt is enough to drive a person to think that the US economic system is broken. The fact that Millennials struggle to reach important milestones – like owning a home – further exacerbates this reality. Owning a home and having a stable job are important elements to making people feel that the “system” works. The fact that Millennials feel shortchanged in both regards makes it clear why they think the system is broken.

It’s all further exacerbated by the expectations that were instilled in Millennials when they were young. Growing up in the ’90s, we were surrounded by prosperity that we assumed was “normal” and would last forever. We walked into a storm with insanely inflated expectations of ourselves and the future.

The feeling of inadequacy is made worse by the fact that, thanks to the internet, we’re constantly exposed to our peers who are doing “better” than us. They are probably fronting to make themselves look better on social media, but it’s easier for a Millennial to feel like they’re falling behind when we look at the picture-perfect lives of our peers on social media.

If you look at your “successful” peers on social media, you see picture perfect families with nice homes and smiling children. No one is posting about the troubles they have paying the daycare bill, or the fight they had with their spouse the other night. They might have a beautiful home, but they’re actually house poor and have little disposable income after they pay the mortgage. They’re not going to post when they were passed over for a promotion at work. No one posts about the bad things in their lives. It’s all smiling faces and a front. It’s easy to look at that and feel like you’ve been left behind.

Anyway, while I completely understand where Millennials are coming from in thinking that the system is broken, they are still completely wrong in their politics. They’re especially wrong because they fail to realize how fortunate they are to simply be born in America. As mentioned earlier, simply being lucky enough to be born in America virtually guarantees you’re going to be in the top 1% of incomes globally.

Even if they don’t really want socialism (I suspect they just want a stronger welfare state, less debt, and an economy that isn’t so boom and bust), I think they are voting for people that do actually want socialism and want to undo the entire system that made our way of life possible.

Warts and all, it’s still the best system in the world. Blowing it up isn’t going to make life any better.

This is another reason to own international stocks. If the US does something insane like go socialist, the rest of the world won’t. Just like every company in an index doesn’t succeed, every country in the world doesn’t always succeed. Own all of the countries and you get some important diversification in case something in one country goes wrong.

If you’re going to own a lot of different companies, why not own a lot of different countries for the same reason?

Owning international stocks isn’t just about creating more consistent returns. It’s also about diversifying political risk against the possibility that the US economic system – which has worked so well for so long – could be upended by bad politics and an angry electorate.

I hope the US remain the premier world economy. I think it probably will stay at the top. But what if I’m wrong? That’s why I own international stocks. If the US goes down the wrong path, I don’t think that the entire world will follow. Diversification among countries is just as important as diversification among companies.

Bonds aren’t a waste of time

I wrote about owning bonds in my post, are bonds for losers?

While stocks are virtually guaranteed to outperform bonds over the long term, bonds can help contain drawdowns. Most people underestimate their capacity for financial pain and bonds can help limit that pain.

On the surface, going 100% stocks is the way to go. Since 1871, stocks have offered a real return of 6.87%. Bonds offered a return of 2.51%. 60/40 offered a 5.54% return. Why not go for the higher returns and just go all-in on US stocks?

The drawback of owning 100% stocks is that they can undergo truly horrific drawdowns that can take years to recover from. US stocks were flat in real terms from 2000-2012. 12 years of sideways markets is rough. From 1964 to 1981 (17 years), US stocks only delivered a real return of 1.32% from 1929 to 1948 (19 years).

Can your long term investing plan sustain multiple decades of flat real returns?

It’s easy to look at a long term chart of US stocks, or a long-term CAGR, and brush off these drawdowns. Living through them is a completely different matter.

In the early 2000s, US stocks suffered a 44% drawdown. From 2007-2009, stocks suffered a 50% drawdown. Imagine you had a 100% stock portfolio. Also, imagine you had a significant amount of money saved up, like $500,000. A 50% loss is $250,000. That’s a decent house in most parts of the country. Would you have been able to “stay the course” in the face of those kinds of losses? I think most people are kidding themselves if they think they will behave rationally in those situations.

For most people, I think the answer is no. Just imagine what it’s like to experience these kind of drawdowns:

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These kind of severe drawdowns can make a person behave irrationally. A big part of the problem is that these drawdowns aren’t just numbers on a brokerage statement. Markets are reacting to very real and very bad circumstances in the real world.

After a nasty drawdown, it’s easy to get caught up in the mentality that the economy is ending and something is fundamentally wrong.

In 1929-32, it looked like the US was unraveling at the seams. We went from the ’20s, a time in which anything seemed possible (imagine starting a decade without plumbing or electricity and ending it with a stock market boom), to soup lines and hobo villages.

In the 1973-74, there was a widespread feeling that the post-World-War II prosperity was unraveling. The country was running out of oil. The decade prior was a political horror show: the assassinations of JFK, Martin Luther King, Robert Kennedy. Protests in the streets. Dead students at Kent State. We lost a war for the first time in history and lost 50,000 of our young men. Our President was unmasked as a corrupt man who resigned from office instead of face impeachment. Double digit inflation further eroded our standards of living. They called it malaise and it was a widespread feeling that America’s best days were behind us.

The early 2000’s debacle was marked by a feeling that the ’90s was nothing but a bubble economy and we were now going to pay a price. The turn of the millennium and the late ’90s was associated with extraordinary optimism about the future. We had a glorious party and now we were hungover. Add to that the experience of 9/11, this feeling became particularly palpable.

We all remember 2008, but at that moment, it felt like the entire economic system was falling apart.

During a serious stock drawdown, you get the general feeling that the world is falling apart. Stock aren’t drawing down for no reason. They’re drawing down for reasons of psychology that go beyond CAGR’s and numbers on a brokerage statement. Serious drawdowns are caused by a cultural mood. The mood is going to affect the psychology of an investor.

Moments like these also increase the odds of personal struggles, like the potential loss of a job or a house, which further add to the stress of the situation.

It’s easy to see why most investors won’t behave rationally during these situations. In many cases, they’re going to wind up selling their stocks are the worst possible moment when stocks are bottoming. Bear markets start with a feeling of uneasiness towards the boom, they intensify with a general feeling of malaise, and they capitulate when the situation feels utterly hopeless. Of course, the moments when everyone feels hopeless that are the best times to buy stocks.

drawdown10k

I own bonds to smooth out the ride and keep myself behaving correctly. My age might suggest that it’s not a good idea, but I know that I won’t “stay the course” if my 401(k) balance drops 50% and I’m worried about losing my job. While most financial planners would say I’m not aggressive enough (the 401-k website usually gives me the yellow light because my investments are “too conservative”), I want to limit my drawdowns and I know bonds are the best way to accomplish that.

A 100% stock investor might simply throw in the towel completely. This is what many of them do.

When the losses are cushioned with something like a 60/40 approach, it is easier to stay the course and not give up.

The Drawbacks of Market Cap Weighting

The index fund is an extraordinary creation. It allows everyday investors like myself to access the public markets for a low fee. Fees are a tremendous drag on returns.

As far as I’m concerned, a monument should be built to Jack Bogle for creating such an amazing product for every day investors, who were previously swindled out of commissions and paid extraordinary fees to access public markets.

The theory behind market cap weighted indexes is intuitive and easy to understand. Active investors are making bets against each other, trying to outperform each other. This is a zero sum game: for every winning trade, there is someone on the other side making the wrong decision. This is why most active investors underperform. Only some of them can be winners. Add fees to the equation and it becomes even more difficult to outperform.

So, why not simply own the market cap weighted index and get the average rate of return?

There is one problem with this approach: nearly every strategy that moves away from market cap weighting outperforms over the long-run.

  1. Fundamentally weighted indexes outperform.
  2. Equally weighted indexes outperform.
  3. The 30 stocks in the Dow Jones Industrial Average outperforms market cap weighted US stocks.
  4. Completely random 30 stock portfolios outperform the market.
  5. Low volatility strategies outperform, while also containing drawdowns.
  6. Nearly every AAII stock screener outperforms the market.

Finally, all the research and data shows that a pivot towards smaller, cheaper stocks outperforms over the long run.

equities

Small value is the best performing asset class since 1972. However, it notably under-performed during the bull markets of the 2010’s and the 1990’s.

Large cap growth – one of the worst performing long term strategies – also dramatically outperformed in both the 2010’s and the 1990’s bull markets.

Why do non market cap weighted strategies outperform over the long haul and under-perform during bull markets?

I think all of these strategies (equal weight, small size, value, fundamental weight, random portfolios) outperform because they pivot away from the coolest stocks. The coolest, biggest, stocks – the leaders of a bull market – are systematically avoided by all of these strategies. This causes all of these strategies to under-perform in a rip-roaring bull market, which are led by those large cap growth stocks. Meanwhile, non market-cap-weighted strategies also avoid the inevitable horrific decline in these bull market leaders. Over the long run, they outperform.

I think value, in particular, outperforms because it is systematically buying cheap stocks and selling when they get expensive. I talk about that in this post.

Meanwhile, a market cap weighted index is going to buy more of the largest, coolest, stocks as they go up.

As a value investor, I think that the opposite strategy is the best approach.

The ’90s bubble is a good example. In 2000, the market was concentrated in a handful of bubble names. This drove your returns during the bull and made them worse during the bear. If you avoided the leaders of the ’90s bull during the early 2000’s meltdown, then you dramatically improved your long term returns.

For an extreme example of this kind of behavior, look to Japan. James Montier demonstrated that the magic formula delivered a 16.5% rate of return during Japan’s meltdown in the ’90s and 2000’s. The magic formula outperformed because it avoided the biggest stocks in that market and pivoted towards value. This likely caused the strategy to under-perform during Japan’s long bull market. Even in a market that overall was doing poorly, pivoting away from market cap weighting made it possible to earn a high rate of return.

Meanwhile, if every strategy outperforms market cap weighting, then why do most active managers under-perform?

I think the answer is simple: those active managers have the same biases of the index itself. They are going to pile into the same outperforming stocks that the index is piling into it. This is for career reasons. The best performing stocks are safe to own. If you own them and succeed, you’re a genius. If you own them and fail, well, you’re with everyone else.

Active managers and institutional investors aren’t the smart money. They are most of the money and, therefore, most of the market. They’re subject to the same behavioral flaws and biases as everyone else. They discard under-performing strategies, they get excited about whatever is hot at the moment.

It’s also driven by FOMO. Most of them will probably load up on these stocks in an even more extreme way than the index itself. Not only that, but the size of most institutional investors, makes them pivot towards large caps out of of necessity.

Conclusion

I don’t think owning 100% market cap weighted US stocks is the optimal approach.

I think diversification adds a lot to a portfolio. Adding bonds can limit drawdowns. Adding international stocks helps diversify political and currency risks and leads to more consistent returns.

Pivoting away from market cap weighting limits returns during bull markets, but leads to long term out-performance by systematically avoiding the most exciting large cap names.

While indexing in 100% US stocks is likely to do fine over the long run, I think a more balanced portfolio with pivots towards value is a more optimal approach.

Of course, this depends on your perspective. Portfolios are personal. I’m someone who doesn’t experience FOMO. If other investors are outperforming me, I don’t really care. If it drives you absolutely crazy to underperform, then market cap weighting might be for you. If you don’t believe value is a factor likely to persist, you might want to own more market cap weighted indexes.

You do you, but you should go into an investment strategy with a full understanding of the risks and potential rewards.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Podcast on Asset Allocation

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Trey Henninger graciously had me on his podcast again to discuss my approach to an ETF asset allocation that helps me sleep at night.  You can listen here.

If you would like to read about my approach, you can click here.

Also, please note that this was before my change of heart on gold vs. TIPS, which you can read about here.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.