Life would be much easier if we could predict the future. But even with their collective knowledge and wisdom, investors as a group-the market-can't predict the future.
You can take comfort in knowing that you do have a reliable indicator of how risky a stock or bond holding is. Just check its price. Now studies by Marlena Lee, a research associate at Dimensional Fund Advisors (DFA), show that markets reliably price the chances that a country's GDP will grow.
At first, the result may seem counterintuitive: Between 1971 and 2008, the developed countries in MSCI's indexes whose economies were growing, after inflation, produced stock returns six basis points lower than those countries where the economy was shrinking.
The outcome is logical if you focus on risk.Investors already knew that those countries had successful economies and considered their stocks less risky, hence the smaller returns. Less risk means less return, of course. So the fact that China and Brazil are growing quickly-and that everybody knows it-suggests the returns in their stock markets will be smaller than in a shakier economy.
Looking at emerging markets from 2001 to 2008, if you chose to put your money in one that was lagging behind, you could pick up an extra 4.8 percentage points in return.
On the other hand, the high debt and deficits in the United States don't make U.S. bonds a bad investment at current yields, which reflect the risk involved. "People fear that bond yields will go up and returns will go down," Lee says. "But the information about when-the timing-is in today's yield curve. So there's really no way touse the information to predict where the yield or return is going."
The U.S. stock market is also not a bad investment simply because the economy is growing slowly. Lee suggests that financial advisors think of low-growth countries as similar to value stocks, which grow more slowly than growth stocks, but bring higher returns over time.
Lee says that studies of developed economies going as far back as 1900 reached the same conclusion, that faster economic growth produces smaller stock returns. Research that added up earnings at all the companies in a country's stock market, rather than looking at GDP to measure economic growth, also produced the same results, according to the researcher.
So what does Lee suggest for advisors' clients? Most are overweighted toward U.S. stocks,
Lee and Weston Wellington, vice president for investment strategies at DFA, argue for a diversified global portfolio, but not because countries abroad will grow faster than the United States. The reason is to spread your risk. Says Lee, "Why not just hold the whole basket of countries and not be overexposed to one?"