If you are going beyond pure index investing, your job always gets harder. Indexing is great and offers acceptable long term returns for most investors. However, if you want to branch out beyond index investing and enhance things like return versus volatility, then it will take stepping away from the index which requires some investment bets on where certain markets will go.

For my part, I have an overall macro thesis which I start with. I drill down progressively lower until I get to the point of how my macro thesis will affect countries, industry sectors and even individual stocks. This is typically called the top down method in the investing world, each of us has our own investing personality and this is just the one that suits me best.

My global and medium term view now, which I explained in my last post, is bullish foreign stocks, both developed and emerging as well as being bearish on the US dollar. That is not to say that the US won’t grow, I see a big temporary bump coming in US corporate profits over the next 6-9 months given the low rates and massive stimulus we are seeing play out. Rather it is a call on the fact that this stimulus will be dollar negative as the Fed buys up more debt and higher consumer spending will means the purchase of more imports. With the tailwind of a lower dollar at their backs, even a mild bump in foreign company profits will be even higher in dollar terms as both currency appreciation and higher profits work for a dollar based investor. Still, sector bets within the US will still be very profitable, I don’t see anything stopping or slowing down the home building sector, captured through the iShares US Home Construction ETF, ITB, which is up 17% year to date.

I also see a rotation out of growth towards value. Growth stocks have greatly outperformed value stocks over the past decade. The Russell 1000 Growth index has returned about 17% annually since 2010 while the Russell 1000 Value Index has returned about 10%. As investors piled into growth, especially since the pandemic, it has produced a stunning rally in just about everything tech reminiscent of the Dot Com Bubble. It has also produced what has been called a “dash to trash” which has pushed indexes like the Russell Microcap Index, as seen below through its iShares ETF IWC, up 160% in the last year.

The current largest holding of this index is GameStop, which gives you an idea of the potential volatility of the index.

Why You Need a View

I give you my thesis and these examples because in order to branch out from index funds, it’s important to understand that diversification cannot always be easily achieved in one fund for an individual investor. The target date retirement funds that many of our 401(k) plans default to are balanced between equity and fixed income and hold more fixed income as we age but they also tend to be concentrated on large cap stocks. Two examples of this are in the ETF’s VTI and VEU. VTI captures the entire US stock market but is weighted my market cap. What this means is that you will be diversified by holding thousands of different shares but it will really be the large cap stocks like Apple and Microsoft that will dominate your return. Right now those top 10 stocks which you see displayed below account for 22.6% of VTI. Tech accounts for about 25% of the whole ETF.

One way as an individual investor to further diversify is to purchases indexes that track small cap and mid cap stocks. Although these tend to be more volatile they also tend to outperform large cap stocks over time. As measured by Wilshire indexes, which track the universe of stocks in a particular market cap in the US, since 2000, small caps and micro caps have outperformed large caps by 252% overall. For the past 10 years however, large caps have been outperforming. This is one reason that a large cap blend fund like VTI risks underperformance over time and why many analysts are calling for small caps to mean revert and beat large cap stocks over the next decade.

Combine this with a tilt towards international stocks also with emerging market growth and mean reversion in mind.

Gun Shye

So given all these macro factors and the fact that my retirement was conservatively invested in both large cap and growth funds, I decided to tilt my brokerage account towards the areas that may be lacking in my overall portfolio: value, small caps, mid caps and large cap international. I looked across different national stock markets as well and picked out a few that I thought were cheap based on relative value such as the UK.

I am comfortable with my calls on emerging markets as well as small cap stocks over the long term however, it’s the value space where not long after investing, I started to second guess myself.

Certain markets internationally have underperformed for years if not decades. You have to be careful when picking value sectors internationally because of this. Some stock markets are riddled with dud value companies that have been limping along with years in a slow growth economy. No stock market embodies this better than Japan. Japan’s Nikkei 225 hit an all time high of 38,915 in December of 1989 and has yet to reach that peak, although it recently surpassed the 30,000 milestone for the first time in 3 decades.

When you venture into the value sector internationally and the indexes are ranked by market cap, you can end up with a big exposure to markets like the UK and Japan which have underperformed over the longer term. To see how this allocation based on market cap for value plays out, take a look at one fund I invested in, iShares EFV, which tracks the MSCI EAFE Value Index. The country breakdown is displayed below.

43% of the fund is allocated towards Japan and the UK. This is fine as I feel those markets are fairly valued, even on a long term basis but I want to capture a more balanced developed country exposure. My additional exposure to the UK I felt left me overexposed to the UK and Japan.

Detecting Cognitive Bias

My dilemma is a common one, I made the decision to invest, pulled the trigger and let as the market has been choppy a bit over the past 2 weeks, let the price fluctuation lead to me second guessing my picks. This is a common sentiment and one reason that some of the great investors like Charlie Munger advise to make your pick and then go on vacation and don’t look at the markets for a few weeks.

Yet as with anything, I believe you have to make room for admitting mistakes. It’s one reason why keeping an investing journal is a great idea. You can write down why you invested in something, the logic you used and why, and then go back later and revisit where your logic was off or your timing was off. As I still believe that my logic was sound, it’s also worth allowing yourself space to adjust mistakes in the implementation of your logic as you go along.

In my case, my bet on value and international stocks became an unintended bet on Japan and the UK, which was not the bet I was looking to make. Rather I was looking for a less lumpy international developed market investment to take advantage of various currencies appreciating against the dollar as well as the reasonable prices of their stocks. One solution for this would be to quickly pair down my investment in EFV and move those funds into the Vanguard International Dividend Appreciation ETF, which balances holdings within emerging as well as developed markets and doesn’t have one country representing more than 14% of the fund.

Allocating to this fund will allow me to better diversify and avoid the overexposure that indexes based on market cap can bring.

The moral of this is that it’s ok to make a mistake, even when you feel you are diversified across countries and sectors. The key is to recognize this and act on it rather than just watch your investments sink and let fear paralyze you into inaction. The reason many people fail at investing is because they don’t even try in the first place. Keeping an investing journal and admitting reviewing your logic will help wonders with this.

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