NoBody Knows – And That is Why You Diversify

the sun tarot– Nobody knew that the yield on the 10 year Treasury would keep going down.

– Nobody knew that the price of a barrel of oil would drop by 55%.

– Nobody knew the Russian ruble would crash.

– Nobody knew that Japan would dip into a technical recession.

– Nobody knew that Europe’s tentative recovery would falter and fail.

And this week, nobody knew, including Christine LaGarde, the director of the International Monetary Fund, that Switzerland was going to un-peg the Swiss Franc from the Euro.

These are just a few of the surprises that happened in the last year that even the most experienced investors didn’t predict. These unexpected events can have either a positive or negative effect on stock and bond markets worldwide. Unexpected events like these are also why most investment professionals, including me, espouse the mantra of diversification.

You’ve probably read about diversification in your employee benefits package when signing up for your 401 (k) or from reading investment articles or from your financial advisor. Diversification is what it sounds like – an investment strategy that combines a variety of investments (both U.S. and international, a mix of small and large cap stocks, and a variety of bonds) designed to reduce exposure to risk. However, diversification doesn’t just reduce the downside potential it also reduces the upside potential, in the end, hopefully providing a smoother portfolio trajectory.

You might say, what?, why would I want to invest in a strategy that reduces the upside potential? Well, if you knew anyone that bailed out of stocks in 2008 or early 2009 and never reinvested, you will know the answer to that question. A portfolio with 100% invested in the S&P 500 in 2008 lost 37%, and if it had a good dose of large technology stocks even more (the NASDAQ Composite was down 41%). That unfortunate time in stock market history scared off a lot of seasoned and unseasoned investors. If instead, that 2008 portfolio was diversified with a dose of bonds in it, the loss would have been less and the investor, more likely to stay in the market. Which is the point – less volatility is more likely to keep a person invested for the long haul.

In 2014, the more diversified your portfolio was, the less closely it would have matched the returns of the S&P 500, which was up 13.69%. The S&P 500 is the index along with the Dow Jones Industrial Average, (up 7.52% in 2014) most often quoted in the media. Below are the 2014 returns of various indexes representing the broader asset classes and geographic areas you would find in a diversified portfolio:

REITS (Real Estate Stocks)                 28.0%
Inter.Term Bonds                                5.97%
US Small Cap Stocks                           4.90%
Global Stocks (includes US)                4.0%
Hi-Yield Bonds                                    2.46%
Emerging Markets Stocks                  -1.8%
International Stocks                           -4.90%
Global Diversified Bonds                   -5.72%
Europe Stocks                                     -7.10%
Pacific Stocks                                      -7.10%
Commodities(includes oil&gas)        -17.01%
Russia Stocks                                       -44.9%

As you can see, the returns were all over the map, and mostly down. It was not a great year to invest internationally and definitely not in energy stocks. But nobody could predict that going into 2014, in fact, back then it the world looked like it was poised for synchronized global growth.

If you were in a diversified portfolio, you had another decent year, maybe nothing to jump up and down on the bed about, but decent. And, the good thing about decent years, even single digit ones, is that they add up over time.

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For additional food for thought on this topic, the attached charts illustrate the randomness of asset class and sector return year by year. Please note that the “AA” or Asset Allocator portfolio was created by novelinvestor.com and is for illustration purposes only.


asset class returns

s&P 500 sector returns

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