Wednesday, February 4, 2015

Diversification Strikes Back

Let’s revisit the investment year of 2014:

               -S&P 500 (large cap stocks): +13.69%
               -Russell 2000 (small cap stocks): +4.89%
               -iShares MSCI EAFE (international stocks): -7.09%

These returns caused a lot of confusion and frustration among investors. A well diversified investor who allocated a third of their portfolio into each of these asset categories achieved a return of only 3.83% during the year. Meanwhile, most people use only large cap indexes such as the Dow Jones Industrial Average, the NASDAQ, or the S&P 500 as a metric for how markets are performing. Consequently, after hearing how these large cap indexes obtained double digits returns during the year, it was challenging for some investors to comprehend why their portfolios obtained returns of only a fraction of what these well known indexes earned. In fact, some investors started to wonder why they own any investments other than large cap U.S. stocks.

Now let’s examine investment returns during the first month of 2015 (thru January 29th):

   -S&P 500 (large cap stocks): -1.73%
               -Russell 2000 (small cap stocks): -1.16%
               -iShares MSCI EAFE (international stocks): +2.38%

As you can see, 2015 asset category performance is essentially inversely related to how the asset classes performed in 2014. Large cap stocks, the best performing asset category in 2014, has so far been the worst asset category in 2015, while international stocks, 2014’s biggest loser, has been 2015’s biggest winner.

These figures provide a useful reminder of the value of diversification. In January, while large cap stocks lost -1.73% a diversified portfolio with a third of all funds invested in each asset category would have only lost -0.17%. 

For this exercise, let’s annualize January’s returns. In this case, the large cap portfolio would suffer an annual loss of -20.76% while a diversified portfolio with a third of all funds invested in each asset category would have lost -2.04% during a full year. While this isn’t an optimistic projection for 2015, it illustrates the value of both diversification and investing for the long term.

The last step in our exercise is to examine the 2014-2015 investment period we have now created, in which our large cap portfolio earned 13.69% in 2014 and lost -20.76% in 2015 while our diversified portfolio made only 3.83% in year one but lost only -2.04% in year two:

After 2014
After 2015
Invest $10,000 in Large Cap Stocks
Invest $10,000 in Equally Weighted Portfolio

Assuming $10,000 were invested in each of these strategies, at the end of our two-year period the large cap portfolio would be worth $9,008.79 and the diversified portfolio would be worth $10,171.19.

Of course, we have no idea whether large cap stocks will continue to decline throughout the year, or if international stocks will continue increasing in value, but that is the point! Our hypothetical scenario reminds us that as investors, we should be investing with a focus on the long-term. Consequently, our goal should never be to obtain the largest return over a short time period, but rather to achieve the best investment performance possible over an extended time period while minimizing the volatility of our returns. Examining market history provides example after example concluding that maintaining a well diversified portfolio is the best method to achieving this goal.

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