Learn the Right Lesson From 2013

2013 was viewed as a very positive year by investors. The S&P 500 index (measuring large cap U.S. stocks) was up 32.39% for the year. However, the reality is most other asset categories didn’t come close to keeping up with the pace set by U.S. equities. For instance:

• Foreign Stocks (IEFA): 22.46%
• Emerging Markets (IEMG): -2.77%
• Real Estate (IYR): 1.16%
• US Government Bonds (IEF): -6.09%
• US TIPS (TIP): -8.49%
• Corporate Bonds (LQD): -2.00%
• International Bonds (IGOV): -1.37%
• Emerging Market Bonds (LEMB): -6.73%
• Commodities (DJP): -11.12%
• Gold (GLD): -28.33%

In retrospect, the way to maximize your gain last year would have been to hold a completely undiversified portfolio consisting of nothing but U.S. stocks. The danger going forward is to learn the wrong lesson from 2013. Investors always have the temptation to fall prey to the recency effect, continuing and exaggerating the behaviors that worked in the recent past believing the environment we’ve just been through will be permanent.

Many will abandon their investment strategy because it didn’t give them the absolute best result last year, failing to recognize the long-term benefit of diversification. I’d argue that a better perspective is to remind yourself that the definition of diversification is that you always dislike a portion of your portfolio. Even in the most widely prosperous market environment, a truly diversified portfolio will have an element or two that lags the market. In fact, if at any time a portion of your portfolio isn’t generating negative returns, you should be concerned about a lack of diversification in your investment strategy.

Now is an ideal time to review your asset allocation and remind yourself why we diversify. Modifying your allocation with a focus on what happened in 2013 would be similar to guessing a coin flip will land on tails because it did on the previous flip. The correct lesson to take from 2013 is that over time, a well-diversified portfolio is capable of producing sufficient returns to help you reach your investment goals while minimizing risk.