If investing were a religion, one of its most profound teachings would be the gospel of diversifying your investments across the broad spectrum of asset classes.
Academic research and investment history have demonstrated that this kind of investing potentially reduces portfolio risk, while allowing investors to participate in the long-term potential of investing in the capital markets.
Testimony from the Diversification Congregation
Doesn’t this sound wonderful? Isn’t this a “congregation” you want to join? Perhaps not! Diversification as an investment strategy actually came under intense criticism for poor performance during the 2008-2009 financial crisis. Those loud critiques have continued in the years since due to the somewhat uninspiring returns of broadly diversified portfolios.
In fact, if one were to review asset class returns over the past five years or even 10 years, diversification has delivered disappointing results when compared to less diversified strategies. You could even make a pretty strong argument that diversification has not only produced lower returns, but has done so with elevated portfolio volatility. Yuck!
These results have important implications for the clients I often meet: mid-life professionals thinking about new career pursuits and/or who are on their way to leaving the workforce soon or in the medium term. It is true that investing requires a long-term focus. However, medium term portfolio risk and potential return may be especially important to monitor and evaluate for those whose circumstances have recently changed and who may be considering retirement or other significant career changes over a five to 10-year time frame.
Such investors may be well served by making thoughtful and conscious choices about their investment strategies, rather than defaulting to any approach, even one as respected as diversification. Just as there are many religious beliefs in the world, there are also different doctrines and approaches to investing.
How Fruitful is Investment Diversification?
The disappointing results go against the almost fervent religious belief that investment professionals often extol about diversification. It seems fitting to write about this topic during my last blog of 2020 and to review whether investors should “convert” to a new investment “faith”.
Before drawing any conclusions, let us first take a look at the data. For the 10-year period ending November 30, 2020, the Standard & Poors 500 Index (the “S&P 500”) delivered an average annual total return of 14.19%, according to LPL Financial.
During that same 10-year period, diversifying asset classes such as foreign stocks and US small cap stocks delivered average annual returns of 6.05% (the MSCI All Country Ex-US Index) and 11.86% (the Standard & Poors Small Cap 600 Index), respectively. These returns, while positive, were substantially less than the S&P 500.
These less than inspiring results beg the question – should we not just own the less diversified S&P 500 Index? As we move into a new year which may likely bring a sustained economic recovery and the possibility that a new investment cycle may be at hand, it seems especially appropriate to ask this question.
My short answer is that we, as investors, should not abandon diversification. However, I do not think that you should just blindly follow the apostles! I have never bought into the dogma which suggests that cookie cutter, mainstream diversification is useful and/or even as moderately helpful as its preachers suggest.
A Redemptive Way to Diversify
The reality is that each investor should thoughtfully approach diversification as a tool to meet their unique objectives. In other words, the question may be less about diversification and more about how to implement diversification given your unique goals and risk tolerance. Regardless of whether you follow the Old Testament, the Koran or the Torah, the key may be in how you apply the teachings of the one you follow to your day-to-day life. I think this same concept applies to the question of diversification and your portfolio.
For example, some investors may have conviction that a particular asset class may offer superior return potential and they are willing to dedicate a large percentage of or all of their assets in their search for high returns. They are willing to accept the risk that may arise from investing in a single asset class or a small handful of sectors. However, such an allocation may not be an appropriate risk and decision for others.
They may want to participate in the benefits of investing, but they prefer to avoid the risk of concentrating their investments in a single asset class like the S&P 500 Index. But wait – doesn’t the S&P 500 represent a diversified portfolio? It is certainly true that this index does possess a degree of diversification because it includes 500 stocks sprinkled across a range of industries. However, it is not as diversified as it may appear!
The Temptation of Diversification
There are over 3,600 publicly traded stocks in the US and over 12,000 around the globe. These other corners of the financial markets present different investment opportunities (and risks, of course) than investing in the S&P 500 Index.
Investing in these other areas might be completely logical for some investors. They may want to avoid the risk of putting all of their eggs in the S&P 500 Index “basket,” even while recognizing that the diversified portfolio may produce lower returns in a given year or even over many years.
Despite the lower returns of diversification over the last decade, investing in market sectors outside the S&P 500 might actually offer some potential these days. That index has provided unusually high returns for many years now and those results most likely will not persist forever. Of course, the challenge with investing is that it is almost impossible to predict when that may occur, even for the world’s most famous and accomplished investors.
Moving into market sectors that may not have done as well over time is very consistent with the benefits of diversification, which is primarily a risk management tool. There are certainly examples of when this kind of diversification has benefited investors. The early 2000s were a period when the S&P 500 Index and technology stocks were greatly overvalued and saw a historic pullback.
Small cap stocks and emerging market stocks were underappreciated at the time but then went on to substantially outperform the S&P 500 Index over the next decade. There is no guarantee that this will play out again, but sometimes investment history does repeat itself.
The Truth and the Light for Mid-Life Professionals
Although diversification cannot at all prevent a portfolio decline, it may be particularly applicable to mid life professionals experiencing transition. The potential risk management benefits of diversification may be especially practical as you approach retirement or a “working retirement” when your income may be lower for a sustained period.
The search for higher returns may not be as useful to such individuals. Diversification’s benefits have the potential to sidestep underappreciated risks without sacrificing the long-term benefits of investing: the possibility of protecting and maybe even growing the purchasing power of your hard earned savings.
Here again, the devil is in the details. Diversifying asset classes like emerging market stocks and small cap equities often fluctuate to a greater extent than US large company stocks. It is important to consider both the potential risks and return opportunities of these diversifying asset classes, especially during a time of career change and economic turbulence.
Irrespective of your goals and situation, this is not the time to look for a new investment church and abandon diversification. The teachings of this important principle remain valid and should be considered (but not blindly followed) in developing your investment strategy.
Diversification never promised the highest returns or that your portfolio value would never fall in value. Those who thought so have unrealistic expectations or were following a false religion. As always, please contact me if I can help you thoughtfully approach these decisions.