Friday, October 24, 2014

The Short-Term Implications of Diversification



Asset allocation is one of the key factors contributing to long-term investment success.  When designing a portfolio that represents their risk tolerance, investors should be aware that a portfolio that is 50% stocks is likely to obtain approximately half of the gain when the market advances but suffer only half the loss when the market declines. 

This general principle frequently holds true over extended investing cycles, but can waiver during shorter holding periods. For example, a fairly typical client of mine who has a 50% stock, 50% bond portfolio has obtained a return of 3.16% over the last 12 months, while the S&P 500 has obtained a return of 11.40% over the same time period (as of 10/20/14). An investor expecting to obtain half the return of the index would anticipate a return of 5.70%, and by this measuring stick, has underperformed the market by over 2.5% during the last year. What caused this differential?

The issue resides in how we define “the market.” In this example, we use the S&P 500 index as a measure for how the market as a whole is performing.  As you may know, the S&P 500 (and the Dow Jones Industrial Average, for that matter) consists solely of large company U.S. stocks.  Of course, a diversified portfolio owns a mixture of large, mid, and small cap U.S. stocks, as well as international and emerging market equities. Consequently, comparing the performance of a basket of only large cap stocks to the performance of a diversified portfolio made up of a variety of different asset classes isn’t an apples-to-apples comparison.

Frequently, the diversified portfolio will outperform the non-diversified large cap index because several of the components of the diversified portfolio will obtain higher returns than those achieved by large cap holdings. However, the past 12 months has been a case where a diversified portfolio underperformed the large cap index because large cap stocks were the best performing asset class over the time period.  In fact, over the last twelve months, there has been a direct correlation between company size and stock performance (as of 10/20/14):

Large Cap Stocks (S&P 500): 11.40%
Mid Cap Stocks (Russell Mid Cap): 7.08%
Small Cap Stocks (Russell 2000): -0.49%
International Stocks (Dow Jones Developed Markets): -3.21%
Emerging Market Stocks (iShares MSCI Emerging Markets): -4.09%

Since large cap stocks were the best performing element of a diversified portfolio over the last 12 months, in retrospect, an investor would have obtained a superior return by owning only large cap stocks during the period as opposed to owning a diversified mix of different equities. Does this mean owning only large cap stocks rather than a diversified portfolio is the best investment approach going forward? Of course not. Year after year, we don’t know which asset category will provide the best return and a diversified portfolio ensures we have exposure to each year’s big winner. Additionally, although large caps were this year’s winner, they could easily be next year’s big loser, and a diversified portfolio ensures we don’t have all our investment eggs in one basket.

Don’t be overly concerned if your diversified portfolio is underperforming a non-diversified benchmark over a short period of time. As always, long-term results should be more heavily weighted than short-term swings, and having a diversified portfolio is likely to maximize the probability of coming out ahead over an extended period.

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