Feel like diversification is causing you to miss opportunities?
Being diversified can be painful in the short run.
For the 2nd year in a row, most diversified investors started off the New Year by opening up their 4th quarter statements and found themselves greeted with relative disappointment. The reason for the let down this year was that once again, being diversified can be painful in the short run.
For the 2nd year in a row, financial advisors are being asked “why do I own all of these foreign stocks and small company stocks? Why can’t we just buy the S&P 500 index and be done with it?”
Like most advisors, I wish it were that simple. However, this is one of those times where we should take the opportunity to look back and see if history can teach us anything about where things stand.
Imagine 2 hypothetical investors, who we will simply call Investor A and Investor B
Investor A started her investment plan on January 1st of 2000. She put 50% of her money in the Vanguard S&P 500 index (Chart A below) and 50% in a diversified portfolio, which included several major asset classes as opposed to just large US Stocks. (Chart B below). Fifteen years later her Vanguard S&P 500 investment had average 4.23% per year. Her diversified portfolio, on the other hand, averaged 8.11% per year during this exact same period. Investor A loves diversification and fully understands how it works to her advantage.
Investor B got a later start on his investment plan and in fact, didn’t start investing until January of 2010. He also put 50% of his money in the Vanguard S&P 500 index and 50% in a diversified portfolio, which included several major asset classes as opposed to just large US Stocks. Four years later his Vanguard S&P 500 investment had averaged 15.42% per year while his diversified portfolio had averaged only 6.58% per year. Investor B hates diversification and can’t understand why anyone would want to be diversified.
As you can imagine, we don’t know if today is January of 2000 or January of 2010
What we do know is that over the long term, diversification works. We also know that 90% of one’s rate of return stems from their asset allocation, meaning how risky or conservative they choose to be, as opposed to their individual investments. This is important because your asset allocation is something you can control, whereas how well an individual investment performs is not. Just remember, what goes up can just as quickly come back down. Between 1995 and 1999 there was no better place to be than large US growth stocks. But when the party ended in 2000, it ended badly, with consecutive losses of 22.08%, 12.73%, and 23.59% respectively (See Exhibit – Why Diversify? Because Winners Rotate).
The portfolios that we manage for our clients are well diversified and have exposure to all of the asset classes that we mentioned above. In addition to the accounts we manage at Charles Schwab, we also use variable and fixed annuities to lock in predictable future income, and we occasionally recommend private real estate trusts when we feel their strategy and risk profile makes sense for our clients. Diversified investors have had their patience tested over these last 2 years, but that is not a reason to change strategies.
We appreciate your confidence in us and greatly value the opportunity to serve as your Wealth Managers.
Chart A – Vanguard 500 Index
Chart B – Global Diversified Portfolio