The best versus the rest

Martin Dietz wrote a great blog last year on the case against American equity exceptionalism. He outlined that the outperformance of US equities has been spectacular over recent years, but investors should beware the lure of recency bias and remain diversified.

The fantastic US returns made me curious, however. How often might we expect that kind of outperformance of one region?

Expect the unexpected

Over the past decade, US equities have outperformed an equal weight[1] of other regions by about 5% per year on average:

The above assumes exposures are currency hedged so the story isn’t complicated by FX moves. To understand how unusual (or not) it is for one region to ‘beat the rest’ by this much, I looked at simulations from our in-house economic scenario generator across the six regions shown above, for a 10-year horizon. For each simulation I compared how well the best-performing region (identified ex-post) did relative to the average of the rest. This is a histogram of the results:

As you can see, the best outperforming the rest by 5% p.a. is a very typical occurrence, broadly a median outcome. This means that one region substantially outperforming the others is far from unusual.

Regret risk?

Of course, after the fact there is bound to be some regret – if only we'd invested 100% in the best one! Hindsight bias can even make us feel like the outcome was somehow inevitable.  Even though there are clues, nobody knows in advance which region that will be. The same model suggests the following chances the different regions are the best performer over the next 10 years:

Emerging market equities have the highest chance according to the model, but obviously come with greater volatility – such a pie chart has limited use for strategic asset allocation decisions.

Nevertheless, we can see that the next winner could be unlikely to be the US. In addition, none of the above analysis considers valuations (our strategic returns are risk-based) – as Martin pointed out, part of the past decade's outperformance is due to US equities becoming more expensive, which may not bode well for future performance.

Failure: the price of success

Diversification[2] is a simple concept in many ways – don’t put your eggs in one basket – and yet can be a cognitively jarring one in practice. This is because with the benefit of hindsight, a diversified strategy never feels like the right approach. It’s too tempting to invent narratives that make past events seem obvious in retrospect. But even those who fully appreciate this may be surprised by how much failure you ought to expect within an efficient portfolio.

The flipside of the above can be worked out by analysing the ex-post worst region versus the others. Perhaps unsurprisingly, we might also expect the worst-performing region to underperform the rest by about 5% per year.

Just as the temptation to focus the portfolio on recent outperformers is strong, so is the urge to ditch recent laggards. If anything, however, this could be precisely the wrong thing to do. Over short periods, such as a couple of months, there is some evidence recent performance could persist – there is some momentum in markets. But over longer periods the reverse is true – there is some (modest) evidence of mean reversion.

The chances are that one region, possibly not the US (although we can’t rule that out), will substantially outperform others over the next 10 years. But lacking a crystal ball, nobody knows which one that will be.

Similarly, one might expect one region to underperform the others, but we don’t know which of these it will be either. The upshot of the above is that we believe investors should diversify, but also prepare to be disappointed that they did!

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[1] Note I've equal weighted just for simplicity – we could use market-cap weights.

[2] It should be noted that diversification is no guarantee against a loss in a declining market.