Sizing Up Global Market Returns

But the Dow and the S&P are outdated benchmarks, says Lance Alston, certified financial planner and president of JWA Financial Group in Dallas. Investors measuring their portfolio's performance against that of the domestic behemoths are not fully accounting for the available opportunities. A diversified portfolio should reflect the global market, not just American blue chips, says Alston.

Too many investors are not diversified enough, according to the planner. In an effort to rectify that — at least for its clients — his firm created the Market Return Benchmark. The average includes some 7,000 stocks drawn from among U.S. large caps (40%), small caps (20%), real estate investment trusts (10%), international large caps (10%), international small caps (10%) and emerging market stocks (10%).

The Market Return Benchmark is a performance yardstick, nothing more. "These percentage allocation targets don't change because of market conditions or economic conditions or anything else like that," Alston says.

But it's also meant to open investors' eyes to the opportunities beyond New York.

This is a Alston's big pitch: Without international equities — particularly international small caps — in your portfolio, you're not diversified and you're missing out on a big chunk of the equity market. "If you look at all the markets total, about 60% of the markets are outside of the U.S. So there's more money outside the U.S. than inside," he says.

SmartMoney.com: Why are the S&P 500 index and the Dow not useful as benchmarks?

Lance Alston: They should be irrelevant. Unfortunately, they are relevant because a lot of people don't diversify enough. They're way overweighted in large U.S. companies, so the S&P is probably giving them a good proxy for their portfolio but not a good proxy for well-diversified portfolios. When you look on most web sites at the financial section, you'll see the Dow, the S&P and Nasdaq.

In our minds, you have to have international [holdings] — not only international, but small-cap international. The large international companies are much more correlated with large U.S. companies. The smaller companies have more of a diversification effect. So international is the first step. Everybody's portfolio has to be personalized to their situation, but we say between 25% and 40% is reasonable for international. If you look at all the markets total, about 60% of the markets are outside of the U.S. So there's more money outside the U.S. than inside.

SM: What about the argument that since so much of U.S. large-cap companies' revenue is derived from overseas that you can hold them in lieu of foreign-based companies?

LA: It is true they may have operations all over world. But research I've seen shows that a company tends to behave like the domicile market. When you look at their returns, their up-and-down movement, they seem to be reacting to the market where it's domiciled. A large U.S. multinational corporation will have behavior similar to the U.S. market and a large European corporation will behave like the European market. There is revenue and operations that are international, but it seems the behavior of the stock is more closely linked to the domiciled market. You have to go beyond the multinationals; you have to go to small caps. That's where you get the diversification beyond domestic boundaries.

And we also look at currency exposure. Movements of the dollar in the last five years has been down and can affect the shares of U.S. companies. If you're buying international companies with dollars, they're priced in yen or euro, so the value of that investment increases.

LA: Our objective was to make it a simple, plain-vanilla snapshot of the world. We're trying to show six or eight asset classes that really should belong in every portfolio. We took out the S&P and instead we use something called CRSP [a stock database]. We built around that and added asset classes like small-cap stocks. You have to diversify and add small-company stocks. We added about 30% international. We have large international stocks, small international stocks and emerging markets stocks.

The S&P 500 was up 5% in 2007. Emerging markets were up 30% to 40% in 2007. If you didn't have that in your portfolio, you missed out on a lot of return outside the U.S. Large international stocks were up 10% to 15% in 2007, which is well above what U.S. stocks did.

The way we built the Market Return Benchmark, we did not include bonds. It's 100% equity stock. That's not the proper portfolio for a lot of people. We left out bonds because that's where you customize it. We think everyone should have every one of these asset classes in the benchmark. With bonds, it varies for everybody. Equities should be straightforward; they all belong. We don't adjust the model on that. When we build portfolios, there are more asset classes. These percentage allocation targets don't change because of market conditions or economic conditions or anything else like that.

SM: What about the Wilshire 5000 Total Market Index? Isn't that a better substitute for commonly used standard indexes?

LA: The Wilshire 5000 is only U.S. companies. It's certainly good people are talking about something that broad, but it doesn't include the international market or real estate.

In our model we overweighted small caps — both international and U.S. — relative to their weighting in world markets. That's a conscious decision knowing that small companies have higher rates of return. We think that's a reasonable approach to building a portfolio.

There are other total market indexes out there. We built ours in 2005, and I think there are some small movements in that direction, to build an internationally diversified index or benchmark. We wanted to build something that's simple and understandable. We want to show the underlying asset classes so people start to think of their portfolios differently.

SM: What happened in 2007? Your benchmark returned slightly less than the S&P.

LA: In 2007, the S&P 500 and our benchmark were probably about even. When you overweight small companies and add international and emerging markets, some or all of those asset classes could underperform the S&P. From 1995-99 there was no place to be but the S&P 500. Just because diversification and adding more asset classes make sense in the long run, it doesn't have to be optimum in the short run. The S&P 500 is almost never the best-performing asset class.

Small caps react worse to recessions. Over the last nine months, there's no question small caps were not the place to be. But they had a fantastic run for six years. If you believe you can pick trends and beat the market, a well-diversified approach is not for you. We don't believe that's possible over the long run.