financial planning diversification

The Truth About Diversification

financial planning diversification

Most investment advisors  (including me) believe that building and maintaining a diversified portfolio is the most prudent way to invest clients’ money.

Not only do numerous studies of asset class* returns support this, but no matter how smart and experienced the advisor is, it’s near impossible to predict with consistency which asset will outperform in any given time frame. That isn’t to say that it doesn’t take skill and expertise to build a diversified portfolio – it does – many metrics come into play such as growth prospects, valuation metrics, and global economic trends.

* There are four broad assets classes:

  • Stocks or equities
  • Fixed income or bonds
  • Money market or cash equivalents
  • Real estate (represented by REITS)

And, within each asset class are sub-asset classes  (or stock sectors) that allow for greater diversification, for example, with the stock asset class, you will find large U.S. stocks, small U.S. stocks, international stocks, and emerging markets stocks. And, within the fixed income asset class are different types of bonds: short-term, hi-yield, muni, etc.

The reality about diversification is that a truly diversified portfolio will not provide the return of the best performing asset over a given time, nor will it match the performance of the worst performing asset. The return will be somewhere in between. Which is precisely the point – the highs are less high, but the lows are less low making it more likely that an investor will not panic and change strategy at exactly the wrong time.

Remember the calmness in the markets in 2017 when all stock sectors seemed to go only up? And, indeed, the returns were pretty amazing: 37.2% for emerging market stocks, 27.4% for S&P 500 growth stocks, and 24.2% for the MSCI (a global stock index) for example. Now, take a look at the chart below which shows returns year to date through June 15, 2018. You can see that the best performing sector so far this year is the Russell 2000 (an index that represents small-cap U.S. Stocks).

And, the worst performing sector is emerging markets stocks (EM Equity). The S&P 500 (representing large U.S. stocks) is up only 2.3%. I’ll wager that there aren’t too many investment advisors that could have predicted that small-cap stocks would be the best performer so far this year, but I can also almost guarantee the portfolios they manage for their clients have an allocation to small-cap stocks.

A truth about investing is that past performance does not predict future results. A great visual of this phenomenon is shown in Callan’s Periodic Table Of Investment Returns – a chart showing annual returns for key indices from 1998-2017. You can see how random the returns are and how easy it might be to try and chase top performers and then be disappointed.

You can liken diversification to the Tortoise, and the Hare story…as the Tortoise said: “slow and steady wins the race.”