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Reiterating Why Diversification Matters

You’ve heard us repeat it regularly: although the keys to reaching your financial goals are very simple, implementation is not necessarily easy. The most important rules are: spend less than you earn, invest your savings regularly, keep your investment expenses low, and diversify your portfolio. Today, we’ll focus on this last rule, and consider the recent outperformance of U.S. stocks versus foreign stocks and bonds.

First, an important concession:  Bill Gates, Jeff Bezos, and other billionaires did not get that rich by diversifying. Rather, their wealth sprang from extremely concentrated exposure to a few incredibly successful investments. Diversification is not a formula for building extreme wealth fast, it is a recipe for achieving financial security and maintaining it. Diversification improves outcomes for most investors. Why is that?

The first reason is that we make better investment decisions when we’re not stressed out. As the recent 2008-2009 period illustrated, when the S&P 500 declined by 57% over more than a year, investors who were only invested in stocks were very likely to feel the urge to liquidate their investments. We all know what happened afterwards with the S&P 500 going up more than 200% from the bottom. During the down leg, high quality bonds provided protection and a balance between stocks and bonds would have proportionally reduced the overall downside—and the odds of panicking.

The second reason: Even absent a dramatic bear market, life circumstances can change unpredictably, entailing serious financial consequences. If those happen while the portfolio is down 15% or 20%, withdrawals will compound the long-term negative impact. Broad diversification reduces the frequency and severity of major portfolio declines, increasing the likelihood that an investor will see her long-term plans come to fruition

One aspect of diversification which frustrates some investors is that, by definition, there will always be sectors of the portfolio which lag (if all asset classes advanced in unison to the same degree, it would not be a diversified portfolio). Over the past 12 months, US stocks are up about 20%–looking at broad indices for large and small companies. International stocks are up less than 5%, while Emerging Markets stocks and US bonds are down (less than 5% and 1% respectively). Almost all our clients have balanced portfolios containing a mix of these categories (and more), and they are all lagging the US stock market (to say nothing of news headlines or their neighbor’s portfolio). We understand the psychological feeling of seeing a segment of your portfolio underperform and drag down the overall return.

It is a common human bias to project recent trends. In other words, when you ask people about the future, they overwhelmingly forecast a continuation of recent events. Psychologists call it recency bias and it results from over-estimating the probability of events which have occurred in the recent past (and are easier to recollect). Take a look at the chart below, which shows the performance of US large stocks, US small stocks, International Stocks (Developed and Emerging Markets), and US bonds ranked by order of best to worst from 2015 through 2018 (year-to-date). For reference, we added the year 2008 to the right.

Those attempting to find a predictable pattern in this data will be unsatisfied—the only certainty is that market leadership changes from year to year (Note for instance the performance from stocks in International Emerging Markets from year to year).  While recent returns may lead investors to project that US stocks are the place to be, we recommend against the urge to sell their bond holdings. A quick glance at the returns from 2008 reminds us why an allocation to high quality bonds is crucial to mitigating portfolio risk.

We believe that this presentation (credit to Callan Associates) makes the case for diversification. Candidly, it is impossible to predict which segment of capital markets will outperform or underperform in the next year or two. By broadly spreading your assets among investments that have historically provided annual returns less than perfectly correlated to one another, our goal is to provide clients with a smoother ride. In doing so, we believe that they are more likely to reach their goals no matter what life throws at them.