While investors know that buying high and selling low isn’t a good strategy, the research shows that individual investors tend to buy after periods of strong performance (when valuations are higher and expected returns are thus lower) and sell after periods of poor performance (when valuations are lower and expected returns are thus higher). Research has found this destructive behavior has led to investors underperforming the very funds in which they invest.
Further compounding the problem is that investors tend to have short memories. For example, it wasn’t long ago that investors were piling into emerging market equities due to their strong performance.
For the five-year period 2003 through 2007, while the S&P 500 Index provided a total return of 83%, the MSCI Emerging Markets Index returned 391% and Dimensional Fund Advisors’ (DFA) Emerging Market Value Fund (DFEVX) returned 546%. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.) How quickly investors forget!
Current Valuations And Expected Returns
The best predictors we have of future returns are current valuations. With that in mind, the table below provides the valuation metrics of Vanguard’s 500 Index Investor (VFINX) and its Emerging Markets Index Fund (VEIEX). Data is from Morningstar as of Jan. 31, 2017.
As you can see, regardless of which value metric we look at, U.S. valuations are now much higher than emerging market valuations. Now, it’s important to understand that doesn’t make international investments a better choice. Their higher valuations simply reflect the fact that investors view the U.S. as a safer place to invest. And as you know, there’s an inverse relationship between risk and expected returns (at least there should be).