Two Markets Worth Investing Into

08/19/2024

The Bottom Line

The S&P 500 & Russell 2000 are two of the best indices to balance average annual returns and risk.

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A few weeks ago, one of our Bratto Biz followers sent me an interesting Treemap plot from the Callan Institute illustrating different annual market returns. He’s a doctor on his investing journey, was curious how to interpret this data, and if he should diversify into other markets like:

• Large Cap Equity (S&P 500)

• Small Cap Equity (Russell 2000)

• Developed ex-U.S. Equity (MSCI World ex USA)

• Emerging Market Equity (MSCI Emerging Markets)

• U.S. Fixed Income (Bloomberg US Aggregate Bond Index)

• High Yield (Bloomberg High Yield Bond Index)

• Global ex-U.S. Fixed Income (Bloomberg Global Aggregate ex US Bond Index)

• Real Estate (FTSE EPRA Nareit Developed REIT Index)

• Cash Equivalent (90-day T-bill)

The below chart lists these markets annual returns in order from highest to lowest each year from 2004-2023.

Some markets stand out in certain years, causing investors to move thousands of dollars chasing last years returns. Real Estate returned 42% in 2006, Emerging Markets 78% in 2009, and in some years like 2022, Cash Equivalents were the only market to generate a positive return at 1.5%. Many American 401k and 403B plans are in target date funds which diversify into many of these markets, but too much diversification into multiple markets will only serve to generate mediocre returns with surprisingly not much reduction in risk. If you have a workplace retirement plan, I recommend you double check what it’s invested into and make sure it’s in a low-cost index fund like the S&P 500 and not a target date fund.

I was curious if it was really worth investing into other markets besides the S&P 500, 100% of my retirement accounts are invested in $FXAIX after all. So, I organized the data and calculated the average annual returns and standard deviations for each market, which is a measure of variation, uncertainty, or risk.

When you look across the markets for the last 20 years, while Emerging Markets have the highest average annual returns, the returns vary wildly with an almost 32% standard deviation. Real Estate has returned a modest 8.40%, but has a pretty high standard deviation of 22%. Fixed Income and Cash Equivalents have the lowest variation of returns, but the returns aren’t very high and will not outpace inflation.

For the last 20 years, US Large-Cap & Small-Cap Equities have offered the best balance between average annual returns & variation of those returns at about 11% and 17-18% respectively, only losing about 1.5% to Emerging Markets returns but cutting your risk in half. High Yielding Bonds were an interesting rival, however losing 3.5% returns for only 1-2% less variation is not worth it to me. If the standard deviation was less than 10% there would be a stronger case to include Bonds in a portfolio.

An equal weighted portfolio of all markets returned an average of 7% with a standard deviation of 15%. Of course, target date funds and other made up portfolios by some financial advisors would weigh this differently, with a strong US Market and Ex-US dominance, but this again just maintains a standard deviation close to the risk profile of US equities while lowering returns. I’ve published several international investing analyses on Seeking Alpha on tickers like VT 0.00%↑ VXUS 0.00%↑ and SCHY 0.00%↑ and have not seen a case to support any allocation in my retirement accounts. If you’re a paid sub of Bratto Biz, you will have access to all my publications like these!

That leaves this big question of small-cap stocks. The market has been gearing up in anticipation of rate cuts, which I don’t support by the way, with a rotation into small-caps being pressured. Due to the volatility and numerous amount of small-cap companies, I’ve always preferred to invest in IWM 0.00%↑ and sell covered calls and strangles against my shares. Though there’s a new income focused ETF IWMI 0.00%↑ by NEOS Investments I’m excited to look at as it may offer both income and some growth using the same options strategy as SPYI 0.00%↑ and QQQI 0.00%↑. I’ve also analyzed a few promising small-cap dividend growth ETFs like VB 0.00%↑ showing excellent dividend growth, but haven’t quite pulled the trigger due to poor returns the past 5 years.

Do you invest in small-cap stocks? I’d love to hear your strategy, comment below or text me on Minnect!