Originally published at: Why a 100% equities portfolio isn’t for everyone – InvestEngine Insights
For a lot of investors, equities are the most attractive investment type when building a portfolio. After all, they tend to offer greater potential returns than assets like bonds and can lead to a portfolio that grows significantly over time.
When building these portfolios, however, it’s important that investors properly assess their willingness and ability to take on investment risk. A lot of investors will invest in global equities – and only global equities – without considering whether pure equity exposure is right for them.
Looking at history, the US market fell 88% in the great depression, and it took 25 years for it to get back to even. Since that recovery, markets have fallen 20% or more 11 times – roughly once every six years. While some investors are happy living with volatility this high in their portfolio, most are not.
Most investors are unlikely to be able to stomach the drawdowns which come with an all-equity portfolio, and will likely damage their long-term returns dramatically by making poor decisions during times of market turbulence (such as selling out after the market drops).
We therefore encourage investors to take our risk tolerance questionnaire as part of our managed portfolio onboarding process. This process more accurately assesses how much risk each investor should be taking in their portfolios, and will then match each investor with a portfolio to match their risk profile. This helps investors rely on the knowledge that their portfolio is appropriate for them, and reduces the risk they will capitulate when the market falls.
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A single risk factor can be dangerous
From a slightly more technical investing perspective, those investing in a passive market-tracking ETF (whether that be S&P or global) are only including a single risk factor in their portfolio.
If the market performs poorly, there are no other sources of risk in the equity portion of the portfolio to offset those losses. Of course, investors should also be considering additional asset classes like bonds to offset these losses, but it’s possible to also include less correlated assets within an investor’s equity exposure.
Over the past 35 years, since academics started analysing the stock market, a small number of equity ‘factors’ have been found to exist, which provide additional sources of return-compensated risk.
These factors include the so-called ‘value’ effect, where stocks with low prices relative to their fundamentals outperform over time, due to a combination of higher risks and human behavioural biases impacting their returns.
Not only does incorporating these factors into portfolios increase the potential for higher risk-adjusted returns, it also increases the reliability of long-term outcomes by reducing the variations in an investor’s long-term potential portfolio values.
By diversifying by risk factor, investors reduce the risk of a single risk premium (e.g. market beta) underperforming for extended periods of time. Academic evidence has shown that even when factor premia expected returns were reduced by 50% (greater than the 30% post-publication shrinkage found in several papers), they still provide substantial benefit in reducing the distribution of terminal wealth outcomes (link to study here)
Our managed portfolios include allocations to these additional risk factors, to provide additional diversification and improve long-term risk-adjusted returns.
If you want to see what regular, long-term investing could do for your finances, try our regular investing calculator.
Why you should avoid a 100% S&P 500 portfolio
Valuations
The US market is expensive, meaning the share prices of US companies are high relative to the earnings they’re generating. The average multiple of an S&P 500 company’s share price relative to its earnings is at 35x, versus the S&P’s average since 1990 of around 27x, and its long-term average of around 18x. This ratio of share price to earnings is called a ‘valuation’ (see left hand side chart):
Charts from JP Morgan’s Guide to the Markets.
While there isn’t a high correlation between high valuations and future returns over the short-run, over the long-run, high valuations are often accompanied by lower long-term returns:
Charts from JP Morgan’s Guide to the Markets.
Given the S&P’s valuation is so high relative to history, the data suggests lower returns for the US market over the next decade. It therefore makes sense to diversify your portfolio away from just the US.
Our managed portfolios include return expectations, based on factors such as current valuations, into the asset allocation process. We’re therefore able to underweight regions with lower expected returns, and overweight regions with higher expected returns.
Concentration risk
The US is a concentrated market, with the top 10 companies making up 34% of the index. And it’s these biggest stocks which are also driving returns.
One stock – NVIDIA – has contributed 25% of the S&P’s entire gain this year (4.36% out of 17.41%).
Over half the S&P’s gain this year has come from just seven stocks (NVIDIA, Meta, Apple, Microsoft, Broadcom, Amazon, Eli Lilly). It’s these big companies which are driving up the S&P, and making the US market even more concentrated.
What happens if these mega-cap companies don’t perform as well as the market expects? This is the risk to investors.
This is a particular risk, as research has found that the largest stocks don’t stay the largest forever. In fact, once a company enters the top 10, its expected return reduces dramatically:
Source: Bridgewater
To mitigate this risk, our managed portfolios are globally diversified, investing in stocks and bonds from around the world. Our portfolios are not reliant on any single region, sector, or country, and we monitor our exposures carefully to ensure we are not taking on any undue risk.
Single country risk
According to academic research, most stocks actually end up being terrible investments.
Markets only rise because a small number of exceptional companies produce returns high enough to offset the vast majority of underperforming stocks.
In fact, market returns are so skewed that between 1990 and 2020 only 2.4% of global stocks accounted for the entirety of global stock market wealth created. Not only that, but over half of stocks (55%) actually underperformed 1-month US treasury bills over the period (link here).
In mathematical terms this is called “positive skewness”, and it’s a finding which has been confirmed across many different markets and regions.
By only investing in the US, an investor is betting that the tiny minority of companies which generate the overwhelming majority of gains going forwards are located in the US. It’s possible they will be, but there are excellent companies located all over the world – and not owning these tiny minority of companies is extremely costly over the long run (given they generate all the gains).
Our managed portfolios include thousands of different companies from all over the world. This ensures that our portfolios are guaranteed to include these winners, and benefit from the positive skew that stock markets have been shown to exhibit.
Currency risk
Sterling-based investors are also making a big bet on the value of sterling if they only invest in the S&P, as the index is priced in US dollars. Investors are therefore suffering from currency volatility in the portfolio.
For example, over the last 3 months, the S&P in USD terms is up 3.5%, but for sterling investors it’s only up 0.7% due to sterling’s recent strength. Investing in only a single USD-priced ETF adds additional uncompensated volatility to a portfolio.
In our managed portfolios, we carefully monitor our FX exposure, making sure we don’t have excessive exposure to any single market, and ensuring we’re diversified across multiple currencies.
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So, to ensure that you avoid making the mistakes we’ve listed here, why not consider a managed portfolio with InvestEngine. Just answer a few quick questions about your financial situation, your attitude to risk and your goals, and we’ll pair you with a portfolio that’s just right for you.
Important information
Capital at risk. The value of your portfolio with InvestEngine can go down as well as up and you may get back less than you invest. ETF costs also apply.
This communication is provided for general information only and should not be construed as advice. If in doubt you may wish to consult a professional adviser for guidance.
Tax treatment depends on personal circumstances and is subject to change, and past performance is not a reliable indicator of future returns.