Dimensional’s 2016 Matrix Book: Strength in Numbers Part 3: Managing the Emotions
The MSCI Emerging Markets Index has been negative in 13 of the past 28 calendar years while the S&P 500 Index has only been negative 5 of the past 28 years. Which index had a higher rate of return in this 28 year time period?
If you’re catching on to the tricky questions we’ve been posing in our last post and the one before that you might guess that, despite the considerably higher number of negative-return years, the MSCI Emerging Markets Index still prevailed in the end with a higher compound rate of return.
You’d be correct. Check out this third in our trio of Dimensional Fund Advisors’ Matrix Book videos to find out how much higher the rate of return was.
Matrix Book Lessons from 2015: Emerging Markets
The illustration here is especially important – not only because of what the results tell us about the markets, but about what they tell us about ourselves.
Dimensional’s Joel Hefner poses a critical question: “Would you have been able to stay the course through all those individual years of negative returns, to actually achieve that higher rate of return from emerging markets?” Based on a number of academic studies on behavioral finance, as well as our own observations, we would propose the odds are slim to none – at least not if you tried to invest exclusively in this single, wildly swinging asset class.
When actually experiencing the emotions from periods of underperformance, it becomes increasingly difficult to acknowledge the logic of the data. Due to behavioral biases such as recency and loss aversion, it becomes easier to overemphasize the recent negative returns and harder to heed what the longer-term data tells us should be our continued course of action.
So, just as there are three key characteristics driving your home’s price (location, location, location), we would suggest that there are three good habits to practice when seeking higher expected returns out of gut-wrenching markets: Diversify, diversify, diversify. Give us a shout if we can help you run the numbers on what your diversified portfolio might look like.
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