Why Bother With Diversification?

Over eight months in and 2013 has been an interesting year for a well diversified investor.  Despite continued fears over high unemployment, a possible end to Fed stimulus and more potential US military action in the Middle East, the US stock market is booming.  Through 8/31/13, the S&P 500 has gained 16.15% and small cap stocks (measured by the Russell 2000) have had a spectacular year, up 20.03%.  But many more diversified investors are scratching their heads, wondering why they aren’t seeing double-digit returns in their own portfolios.

A well diversified investor has (at a minimum) some exposure to bonds and foreign stocks. Through 8/31, developed international markets (represented by the MSCI EAFE) have gained only 8.15%, and emerging markets have fared much worse, losing -10.19%. Bond investors have not fared much better as the Barclay’s Aggregate Bond index is off -2.81%. Any investor diversified outside of US stocks has had these other positions weigh on portfolio returns this year.

Now our behavioral biases kick in again.  “What’s the point of owning bonds?” our malfunctioning brains ask.  Recency bias tries to convince us that the US stock market will always be the best place to be as we project returns from the past few years indefinitely into the future. How short our memories are! Not even five years ago stocks were tumbling and investors rushed into high quality bonds.  People were crying for “Dow 3000” and many had convinced themselves that capitalism as we knew it was over. A client told me that GE suffering financial trouble was the “canary in the coal mine” and markets would never recover. Even as the markets bottomed in early 2009 the consensus of talking heads told us that the US would lag international markets into the recovery, only for the opposite to remain true.

But truly the last time investors questioned (and many shunned) a well diversified portfolio was the late 1990’s.  When the S&P 500 is returning 20%+ for five years in a row, no one wants to have money in bonds, foreign stocks or real estate.  Of course, it wasn’t long before the markets reversed course and tech leaders became laggards and diversified portfolios showed their strength.  The chart below demonstrates perfectly that market returns are random and unpredictable. Parts and pieces of a diversified portfolio win big and then later find themselves at the back of the pack.

Table of Investment Returns 3Q 2013

Click to Enlarge

Finally, please ask yourself: is your goal to earn 15% per year and take 100% of the risk of the stock market? Or does your financial plan have more realistic return goals and the lower risk profile of a more broadly diversified portfolio? Low cost and broadly diversified portfolios may not make for great dinner party fodder, but they may just be the best way to reach your financial goals. Take up a new hobby to chat about at the next neighborhood BBQ, and keep your malfunctioning brain from interfering with your long term investment strategy.

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