Diversification can be just like your Step Brother – sometimes you love him and want to do karate in the garage, and sometimes you hate him and want to “mess” with his drum set.
I’ll explain…
The basic premise of diversification is this: Different types of assets react differently in the exact same market.
On the surface, this probably seems obvious; however, most “investors” have little to no diversification in their portfolio. Maybe this is because it has been so simple to make money in the US Equity markets for the better part of 10 years. To a large degree, diversification has been more of a hindrance than a helper over this specific time period. If anything, it added small amounts of volatility and reduced aggregate returns.
Historically, this is an anomaly.
There are numerous theories on why this has been the case. To simplify, the US Stock Market has just beaten the brakes off the rest of the world for the last 10 years. So why invest in anything but US Stocks?
I’m so glad you asked...
To start, I would like to go on record as pointing out how swiftly greed and complacency can turn into fear and panic. Those “investors” that are all-in on US Equities may have forgotten the chaos that the 2000 tech bubble created or the 2008 collapse produced. But what do I know? If you want to stay 100% US Equities, knock yourself out. It’s worked for the last 10 years!
For the first time in a decade, 2018 finally provided an opportunity for proper diversification to prove its merit and stabilize portfolios. Key word here: PROPER diversification.
Here’s an example. Perhaps our first investor, we’ll call him Brennan, decided he was ready to diversify after 9 years of riding the US Stock Market train. So Brennan, in his infinite wisdom, sold his US Index and bought the World Stock index. Boom! Diversification, right? Not quite. Portfolios that were only diversified among global equities did not experience lowered volatility due to the high correlation between emerging market stock, developed international stock, and domestic stock indices.
High correlation means those asset types move very similarly given the same market conditions.
Now, lets look at our second investor, Dale. Dale is a more savvy long-term investor that believes in diversification across multiple asset types. Dale decided to utilize both global stocks AND GLOBAL BONDS! With this strategy, Dale experienced significantly reduced volatility, relative to just the global stock index that Brennan had invested in.
Let’s take a look at Brennan (orange) vs. Dale (purple) over the last 12 months. Brennan is 100% invested in global stocks while Dale went for a asset mix of 60% global stocks and 40% global bonds.
Dale (purple) has clearly experienced lower volatility and slight out-performance with a very simple 60/40 asset allocation.
But Alex, what happens if we go back a little further?
You know what, I was just about to show you! In order to illustrate a point on how important time frames are, have a look at how Brennan (orange) and Dale (purple) fared in a chart for calendar year 2018:
Dramatic difference.
Dale (purple) is a great example of how diversification can be your best friend.
As a long-term investor and portfolio manager, I champion the benefits of not only diversification, but active management as well. This is a debate for another day. On that day, I will breakdown some silly “Fake News” on active vs. passive; however, today is not that day. (Stay tuned)
Now, for those who have been having a Passive Party for the last 10 years and have the mindset of “buy SPY and don’t look at it, ever, not even if there is a fire!”
Here is an example of when doing zero research and buying the cheapest possible “diversified” investment worked out (of course I say “diversified” because simply buying a domestic stock index IS NOT DIVERSIFICATION) but let’s have a looksee:
Well done. That purple line is you, you passivist, you! You’re a modern day Johnny Templeton with your investment strategy.
Let’s have a quick look at how the same two strategies, US Stock Index (purple) vs. 60% Global Stocks/40% Global Bonds (orange), worked over the preceding 12-year period (2000-2012):
As our nifty visuals clearly depict, performance is relative to time period, and anyone can cherry pick to validate their preferred investment strategy. Active or passive, one thing that can certainly be agreed upon is that basic diversification generally works over a complete market cycle. Bottom to top, back to bottom.
It is freaking ridiculous how few people remember what a bad market looks, smells, and feels like. If you can’t quite remember, here is a reminder:
We were on the verge of such a flaming trash receptacle in Q4 2018. All we really needed for ignition was the Fed to stay the course with interest rates. If you are a Brennan type investor (all stocks), keep that in mind if you are all bulled up on our stock market right now.
In 2018, if you were properly asset allocated with a focus on managing standard deviation and correlation in your portfolio, things should not have been that bad for you (compliance would want me to point out that good and bad is always relative). Expand that out and imagine what another year of volatility would look like based on your current investment strategy. If the picture in your mind is bleak, do something about it!
There are few guarantees in life, but I can confidently say, “doing nothing rarely leads to change.”
There is truly no perfect way to diversify. Mathematically, if you remove all risk, you cannot reasonably expect a return. To that end, the ultimate goal of any long-term investor should be maximizing your return per unit of risk. (Here in the biz, we call this risk adjusted return, check it out).
In order to find the appropriate level and type of diversification, you need to first figure out how much pain you can tolerate. Pain is the red, the bear, the downside, the loss. If the return you need to meet your goals requires more potential pain than you can tolerate, it could be time to adjust your goals, not your risk tolerance. Everyone has a different pain threshold, whether he or she is realistic about defining it is another story entirely. But it needs to be the starting point of any investment strategy.
An interesting way to take some emotion out of managing your expectations is to learn and understand modern portfolio theory (MPT). MPT attempts to simplify risk and return onto a curve. Although I do not necessarily subscribe to this thought process, I feel like it is a great starting point on the road to understanding what to expect in terms of risk/reward.
If the volatility in 2018 didn’t make you think about your investments, I hope that some of this information at least triggers you to think about what you are doing in your portfolio moving forward. If you don’t want to or don’t have time to do dig into the basics I presented above, reach out to your money manager and make sure you have a clear understanding of what you should expect from your money when markets are average, great, and awful. This will not only help manage expectations, but it will also open a dialogue as to whether your actual risk tolerance is a driving force in your investment strategy.
Final Thought:
Hope and fear wreak havoc on investors, and the easiest way to avoid making irrational mistakes is to diversify your portfolio across assets with varying correlations to one another. Owning one passive index fund does NOT provide adequate diversification, even if you theoretically own shares in 500 different stocks.
Disclosures:
Any opinions are those of the author and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance may not be indicative of future results. Diversification and asset allocation do not ensure a profit or protect against a loss. International investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. Investing in emerging markets can be riskier than investing in well-established foreign markets. Investing involves risk and investors may incur a profit or a loss. Investing in certain sectors may involve additional risks and may not be appropriate for all investors. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. The MSCI ACWI (All Country World Index) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. As of June 2007 the MSCI ACWI consisted of 48 country indices comprising 23 developed and 25 emerging market country indices. The developed market country indices included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The emerging market country indices included are: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. Inclusion of these indexes is for illustrative purposes only. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. All illustrated investment profiles are hypothetical and the asset allocations are presented only as examples and are not intended as investment advice. Please consult with your financial advisor if you have any questions about these examples and how they relate to your own financial situation.