Each of the largest emerging market countries have valuations within one standard deviation of their median, implying a normal range of returns going forward. Over the last 50 years, emerging market equities have averaged 12.02% annually. More conservatively we’ll assume the same 9.33% developed international equities earned to set our expectations.
For international stocks in total, we’ll make a rough assumption of 70% in developed and 30% in emerging markets. We should expect a return of .70%*9.33% + .30*9.33 = 9.33% on our international equities.
Now we get to the difficult stuff: real estate, gold and commodities.
Real estate is a bit troubling. We haven’t found any literature pointing to a framework to determine expected returns here (and if you know of any, please share.) Looking at historical data, REITS have averaged 8.90% over the last fifty years, and 8.18% since 2000. Taking a global approach and employing a reasonable amount of conservatism, let’s assume midway between our expectations for U.S. stocks (3.55%) and international stocks (9.33%). Thus, 6.44% seems like a reasonable expectation from REITS.
Gold and commodities are the most difficult to set expectations around, with no intrinsic value, earnings or dividends. Looking at the historical data, gold has averaged 7.83% over the last fifty years, and 8.64% since 2000. Let’s take the lower of the two and assume 7.83% for gold. Similarly, commodities have averaged 6.73% over the last 50 years, but only -0.33% since 2000. To be conservative, let’s average the two periods and end with 3.20% as our outlook for commodities.
I define the diversified portfolio as equally weighted between each asset class; U.S. stocks, U.S. bonds, international stocks, international bonds, real estate, gold and commodities. This is not how I recommend allocating a portfolio, but it is a reasonable way to discuss the features of diversification in general.
The expectation for a diversified portfolio would be 1/7 of each of the individual pieces, or:
(1/7)*3.55% + (1/7)*1.92% + (1/7)*2.00% + (1/7)*9.33% + (1/7)*6.44% + (1/7)*7.83% + (1/7)*3.20% = 4.90%.
As we did with the 70/30 portfolio, we add in the average diversification return. The median diversification return for a diversified portfolio over 10-year periods is 1.12% annually.
Taken together, our expectations for a diversified portfolio are 6.02%. This is almost double the expectation from a 70/30 portfolio. But don’t take my word for it. Plug in your own assumptions and position sizes.
We’ve never been faced with such low expectations on both U.S. equities and U.S. bonds at the same time. Today’s domestic investing market implies that this is possibly the most important time in history for investors to be eschewing home bias and embracing a multi asset class globally diversified portfolio. Let us be clear: the odds seem heavily stacked in the favor of diversification.
Randy Kurtz, CFP, is chief investment officer of DataDriven Advisor LLC.