In nearly every market commentary we mention how important diversification is to an investment portfolio. In 1952 Harry Markowitz introduced Modern Portfolio Theory which further expanded upon the benefits of diversification. The concept seems straightforward and logical yet time and time again many stray from it. The question is why? Why do investors give up on a strategy that "works".
Diversification shows its true benefit over the long run. The issue is there are periods of time where a single asset class’ performance dominates the others. Sometimes these periods can be several years long. For example, from 2004-2007 Emerging Markets returned an impressive ~132.9%. From 2009 to 2012 REITS (Real Estate Investments Trusts) returned ~84%. And more recently, from 2014-Present, the S&P 500 (Large Cap US Stocks) has returned ~60% (as of this writing). No other asset classes have come close to this same performance in those periods. This type of outperformance leads many to abandon diversification and overweight their portfolios with asset classes that have experienced the best returns. Many forget the years prior and after as to how significantly these same asset classes underperformed their peers. We do believe one should slightly overweight or underweight certain asset classes based on macro economic factors, but too much can wreck havoc on a portfolio's long term stability.
Over the past four years, excluding2017, diversification has not treated investors well as Bonds, International, REITS & Emerging Markets have lagged S&P 500 performance. The S&P 500 has shown extreme resiliency at every turn and recently has benefited from corporate tax reform, stock buybacks, and a growing U.S. economy. You may be asking yourself, why not just own this asset class as it's comprised of the 500 largest (or most "important") U.S. publicly traded companies and has been rock solid the past six years? The answer lies in the details. Owning solely the S&P 500 or any other asset class for that matter will most likely lead to a positive return over the long run. The challenge is you will have to deal with long stretches of underperformance that are difficult to endure if all of your money is in a declining or underperforming asset class. Take a look from 2004-2010; the S&P 500 was in the middle of the pack or lower for SIX straight years. While it did yield a positive return, it significantly trailed other asset classes. Both stock and bond markets are forward looking mechanisms so looking at past performance generally is not a recipe for success. Most people would look to jump ship into the better performers. This creates a loop that leads to chasing returns and market timing.
While 2018 really hasn't been kind to diversified portfolios, it is important to remember the goal of diversification is not outperformance. Rather, it is to minimize the fluctuations and earn an efficient risk adjusted return. There are periods in the short term where diversification may not seem effective, but the long-term results speak for themselves. The key to diversification is sticking to it over time and this will challenge you at times. A properly diversified asset allocation portfolio that is rebalanced regularly aims to smooth out the bumps and place your portfolio in the middle to upper middle of the pack most years.