Most investors nowadays are diversified in the traditional sense of the word. Rarely do we see someone with a bulk of their money in one fund or one stock. However, being properly diversified means more than just holding a bunch of different investments. This month I want to take a deeper dive into diversification and how it actually works when done properly. Often the "value" of diversification is shown during prolonged market sell-offs. Examples include the 2008 Financial crisis, the European debt crisis of 2011 and the 4th quarter of 2018.
While many equity asset classes have experienced prolonged bouts of volatility over the past few years, the S&P 500 has been somewhat spared. The last time the the S&P 500 experienced four consecutive monthly declines was during the 2011 European debt crisis. Since then? Only once have we seen three consecutive monthly declines. It's resiliency has been amazing. So, why not just load up with the S&P 500 in your portfolio? While much has been made of the S&P's dominance over the past 5 years, 2000 to 2010 paints a much different picture (S&P 500 is represented by the blue "Large Cap Equity" style box). It was a middle or lower tier performer for 10 consecutive years! It is extremely difficult to stick with an underperforming investment for that long, especially if it's a majority of a portfolio. Remember it's not just how much your portfolio gains, it's also how much less it loses. As investors, we all have a "pain threshold" that prompts us to wave the white flag. One of the most important things in investing is to avoid reaching this pain point and the best way to do this is usually by being properly diversified.
When analyzing portfolio returns, most desire to see all their investment holdings increase at the same rate. This sounds reasonable and logical right? It's actually a dangerous strategy. If all your investment are highly correlated, what happens when one sharply declines? The answer is they all decline sharply. The pain often ends up being too much and poor and emotional decisions usually follow. Diversification helps avoid market timing. If an investor is significantly overweight in an underperforming asset class, odds are they will not only sell at the wrong time, but likely start chasing performance. The idea of "doing something" during a market sell offis a psychological response. It is human nature to see a problem and think "I have to do something now".
Many did take actionduring the 2008 Financial crisis. Most timed it poorly and missed out on the recovery which can often seemingly come out of no where and happen so fast that it is easy to miss out on double digit returns. While most equity asset classes were pummeled during 2008, many only suffered a fraction of the losses. In fact several types of bonds flourished. Proper diversification and stoicism in the face of a market decline is what kept many investors from panicking. This allowed them stay the course and reap the rewards when the market started to recover.
For the first time in nearly half a decade, bonds are outperforming nearly all equity asset classes over a rolling 12 month period. The irony is bond performance significantly lagged equities from mid 2016 to mid 2018. If one focused solely on the individual returns, they would have likely sold bonds at the exact wrong time. This also applies to the various equity asset classes. Currently U.S. stocks comprise ~52% of the global market. If investors ignore international and emerging markets, they are in a sense leaving out almost half of the worlds market cap. The outperformance of International and Emerging markets from 2003-2007 was nothing short of breathtaking. While there are instances where it may make sense to slightly over/underweight certain asset classes, being properly diversified is a must. This is partially why we focus more on the collective portfolio returns and not individual investment returns.
It can be tough to convince yourself of this fact but the truth is your portfolio should almost always have several investments that are lagging the others by a noticeable amount. If not, that is when action should possibly be taken. The goal is to earn an efficient risk adjusted return while reducing volatility via diversification. It is not to have only the top performers over a given period of time. Does this strategy work perfectly? Over the short term the answer is no, but over the long run it does. Solely focusing on individual investments returns does not paint a proper picture and as history has shown, it more often than not leads to lower long term total returns as investors tend to end up chasing returns. Think of your portfolio as a baseball roster. When assembling it, ideally you want a mix of speed and defensive minded players along with contact and power hitters. This way if one or two struggle, the others can pick up some of slack. Would it be fun to assemble an entire roster of power hitters? Sure, but what happens when they go through a prolonged slump? Attendance will surely drop and the fan base will demand a roster shake up. Successful organizations tend to have a proper balance as relying on one is not a successful long term strategy. The same can be said with an investment portfolio. To quote Aristotle, "the whole is greater than the sum of its parts".