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Most of us have heard the concept that investment diversification is the key to a successful individual investment portfolio. This idea leads many financial planners to encourage clients to own a smattering of stock mutual funds that span U.S. large cap to foreign small caps. However, as history demonstrates, this sort of strategy yields not just undesirable results in terms of risk and return, but also higher fee accumulation for the investor.
Most of us still remember 2008. This period gives us a unique look at what diversification intended versus what diversification achieved in a truly “distressed” environment.
During 2008, the S&P 500, Small Cap, Developed International and Emerging Equity markets lost 37%, 34%, 45% and 52%. Taking a general approach of investing evenly across the asset classes, the portfolio would have lost more than the S&P 500. If we examine the past 20 years, the S&P outperforms an evenly allocated portfolio in terms of a risk/return profile.
The recent pandemic presents another case to highlight this trend. From market peak (Feb. 19) through May 8, the S&P 500 is down 13.1% while Small Cap, Emerging Market and Developed Market indexes are down 21.1%, 17.0%, and 18.6%. The idea of diversifying across multiple stock mutual funds once again fails to provide any sort of risk avoidance. This does not even consider the fees that accompany such mutual funds. The fees of an S&P 500 fund or U.S. large cap firm are, on average, lower than the fees charged for small cap or foreign stock mutual funds.
Reality seems to echo Warren Buffett, who famously stated, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
However, diversification does make sense when considering both stocks and bonds. The U.S. Aggregate (bonds) returned 5% in 2008 and 2.5% since Feb. 19. Both history and the present show that, in times of duress, equity classes tend to move in tandem, and any protection offered by diversification among domestic, international, large or small firms is irrelevant. While some investors might argue “they would have known to overweight certain equity classes at certain times,” this logic is hubris. Hindsight is obviously 20/20.
True diversification is achieved only by incorporating bonds. Shifting just 20% of your portfolio from the S&P or any other stock mutual fund into the U.S. Aggregate would have resulted in not only a higher return, but also less risk in our two most recent periods of duress. With interest rates near all-time lows, the expected return of bonds is less than ideal, but the principle stands. True diversification blends both stocks and bonds.
It is important to remember that each person is different in ability and willingness to take on risk. However, the main goal of diversification should be to limit the downside—whether it comes from a housing crash or a pandemic.•
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Blickenstaff is CEO of Titan Investment Management LLC.
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