Diversification – Not if, but When

Most investors know that diversification is a good thing. The simple idea of not putting all of your eggs in one basket is pretty easy to understand.

Even if an investor doesn’t fully grasp the math that explains how a portfolio can be less risky than the sum of its parts, they know that diversification is their friend.

However, knowing something is good for you and actually doing it consistently are two completely different things. For investors, a big challenge arises when our portfolio inevitably performs differently than a commonly cited benchmark or index (e.g. the S&P 500).

More to the point, although over the long-term we anticipate that things will play out a certain way, there can be periods of time when this does not happen. To illustrate this, I pulled together some data to showcase some real world examples of when expectations and experiences differed across several well-known asset classes.

As investors, I think it’s incredibly important that we arm ourselves with this knowledge. This will help us to prepare for periods of time when our convictions will be tested and we may second guess diversification as a strategy. Simply put, it’s not a matter of if these things will happen, but rather when.

Bonds will Outperform Stocks

Annual Data from 1976 to 2014
Stocks
Bonds
Benchmark/Index
S&P 500 Index
Barclays US Agg. Bond Index
Annualized Return
11.61%
7.86%
# of Winning Years
28 (72%)
11 (28%)
Most Consecutive Winning Years
9
3

Very few people dispute the basic premise that over the long-term, stocks have a higher expected return than bonds. If they didn’t, it wouldn’t make any sense for an investor to take on the significantly higher risk.

That said, there have been many periods of time throughout history where bonds have delivered superior returns and less risk. In fact, as you can see in the chart above, roughly one out of every four years since 1976 has been a disappointment to stock investors. Even worse, there have been periods of time (e.g. 2000 to 2002) where stocks underperformed for several years in a row.

Large Caps will Lead Small Caps

Annual Data from 1976 to 2014
Large Cap Stocks
Mid Cap Stocks
Small Cap Stocks
Benchmark/Index
CRSP Deciles 1-2 Index
CRSP Deciles 3-5 Index
CRSP Deciles 6-10 Index
Annualized Return
11.35%
13.70%
14.51%
# of Winning Years
15 (38%)
3 (8%)
21 (54%)
Most Consecutive Winning Years
5
0
8

There is some debate in the academic world regarding the existence of a small cap premium. However, a simple comparison of stocks reveals an inverse relationship between the size of a stock (based on market capitalization) and its returns. Over the 39 year period outlined above, small stocks handily outperformed their large cap cousins by more than 3% per year (mid caps fell in between).

However, if we look closer at the numbers, we see that small caps only outperformed in a bit more than half of the 39 years. Furthermore, periods like the mid- to late-1980s and mid-1990s were particularly unfriendly to small stocks. For those investors who had the discipline to stick to their allocations to small stocks through thick and thin, the rewards were very generous. However, it was incredibly easy to doubt your strategy along the way.

International Stocks will Lag U.S. Stocks

Annual Data from 1988 to 2014
U.S. Stocks
Developed Market Stocks
Emerging Market Stocks
Benchmark/Index
Russell 1000 Index
MSCI EAFE Index
MSCI Emerging Markets Index
Annualized Return
10.80%
5.72%
11.57%
# of Winning Years
10 (37%)
1 (4%)
16 (59%)
Most Consecutive Winning Years
4
1
7

One element of diversification that most investors fail to fully implement is the geographic allocation of their stock portfolio. For U.S. investors, it’s quite common to see portfolios that are 80%, 90%, or even 100% U.S. stocks. When we look at the entire global stock market, however, U.S. stocks actually only make up about 50% its value. Thus, in order to be properly diversified, you need a healthy dose of international equities.

Investing in each of the three asset classes noted in the able above over the last 25 to 30 years has been interesting to say the least. As we would expect, given the higher risk, emerging market stocks delivered the highest anualized return and led the way in 16 of the 27 years in the period. Again, however, that’s still just 59% of the time. The other 41% of the time, emerging market stocks trailed, sometimes by a huge margin. In 1995, for example, U.S. stocks delivered returns of nearly 38%, while emerging markets declined 5% (a 43% gap!).

Lastly, large cap developed market stocks were most certainly a source of frustration during this time period. In general, we would expect the MSCI EAFE Index and the Russell 1000 to perform roughly in line with each other. However, as we’ve discussed, expectations and reality often differ. This is a perfect example.

Closing Thoughts

Even though the evidence is crystal clear that diversification is the only free lunch, the strategy still presents some challenges to the individual investor. Most of these challenges are behavioral and can be overcome. However, they are still very dangerous to your wealth if not handled correctly.

As diversified investors, we need to realize and accept that there will always be an asset class that outperforms our portfolio. Whatever the time period, whether it’s measured in quarters or decades, it’s almost inevitable that you’ll be faced with a feeling of “if only.”

The problem, of course, is that we don’t know in advance which asset class will be the winner. That’s why we diversify.

Nonetheless, the challenge remains the same: Diversification means that if you’re not careful, it’s very easy to second guess your strategy.

For that reason, it’s critically important to have the right expectations about performance before you make any investment decisions. Although a portfolio is designed with a view towards expected returns and expected risk, we need to remember that the future is inherently unknowable.

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