When Diversification Doesn't Work

No one can consistently predict which asset class will be the best performer on an annual basis, the market is just too unpredictable. To eliminate this unpredictability, investors are taught to diversify their investments and spread the risk to various asset classes to reduce volatility and hopefully smooth out long term results. In 2008, an outlier year, almost all asset classes suffered deep losses. 2014 was also an outlier year but for much different reasons.

Last year, diversification likely meant your portfolio did not do great. Diversifying among the major asset classes turned out to be more of a detriment then a blessing in 2014. This was the first time in over 20 years where only one of the major asset classes returned double digits (S&P 500- Large Cap Index) while the rest did not break out of the single digits. When years like this happen, diversification comes into question. I remember hearing the same thing after 2008.

There will be years where this appears to be the case. Historically, over the long run, diversification wins out. While diversification does not guarantee against loss, it is a vital investment strategy. It tends to sometimes limit your returns in a year like 2014 but it can also save you money in a year like 2008. Sure, almost everything was down in 2008 but there is a big difference between losing 30% vs losing 40%. As of this writing he S&P 500 is near the bottom of asset classes for 2015 while International stocks (the worst performer in 2014) are at the top spot. Things are always changing and past performance does not indicate the future.

If you are paying attention you may be wondering, "well, why not shift into whatever was the worst performer last year...buy low, right." Some years this would work out. Others years, however, you would get clobbered. You are on the right track though. This is more what we would deem a tactical move and is one small example of things done in actively managed portfolios vs passively manage portfolios. Anything I would say about passive vs active management is summarized by this great quote

Active management allows for the continuous assessment of the state of the market and to make intentional choices about how best to take advantage of opportunities and mitigate risk. Passive management precludes the ability to add value in this way.

 

Source for returns: https://www.callan.com/research/files/989.pdf

Investments will fluctuate and when redeemed may be worth more or less than when originally invested.