That the stock market hit new highs in July, less than six months following one of the worst market declines in a while, was surprising to most investors. The market shook off the Brexit vote like it was just an annoying fly, and it continues to charge through discouraging economic news and increasing global strife as if they didn't matter. So, it was inevitable that we began hearing from some clients wondering why their portfolios are underperforming Standard & Poor's 500-stock index, which is up more than 18% from its February low, as of July 27.
The inconvenient truth is that diversification is the reason behind their underperformance. It's inconvenient because these are the same clients to whom we have been incessantly preaching the virtues of diversification as the absolute key to positive long-term returns. It is times like these, however, when diversification is bound to disappoint.
Why Diversification Has to Disappoint Sometimes
The challenge for diversified, all-stock portfolios is this recent stock market surge has been narrowly concentrated in domestic, blue chip stocks, as it has been with the stock market rally of the last few years. So, if your portfolio is diversified among several different stock asset classes (i.e., small cap, international, emerging market, etc.), it is not likely going to achieve S&P 500-like performance. In fact, with an optimally diversified portfolio, you are likely to be disappointed with at least a third to as much as half of your portfolio at any particular time.
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It is also times like these, however, when you need to step back and take a long view of the stock market to remind yourself what diversification has helped you achieve in the past and what it is expected to achieve in the future. It is easy to view the market in hindsight and second-guess your strategy; it's not so easy to see and plan for what lies ahead. Diversification is recognition of that uncertainty, and it liberates us from the pressure of having to always be right. Diversification allows us to be vaguely right all of the time, while never being completely wrong. When considered in the long view, and with so much at stake, that's a winning proposition.
You Can't Invest With Hindsight
Consider the performances of S&P 500 stocks and emerging-markets stocks over the past decade. Investors with a diversified stock portfolio may complain that four out of the last five years, emerging market stocks, as measured by the MSCI Emerging Markets index, were a serious drag on S&P 500 stocks. During that period, the MSCI index averaged a negative 4% return, while the S&P 500 averaged about 13%. However, between 2004 and 2010, S&P 500 stocks, which averaged about 6%, were an even bigger drag on emerging-markets stocks, which averaged 25%.
The reality is a diversified portfolio captured the outperformance of both markets in their best years, while smoothing out the risk and volatility of both markets in their worst years. The purpose of a broadly diversified portfolio is to capture the returns of all of the sectors over time but with less volatility at any one time. It is also important to note that, over time, passively managed portfolios of stocks have outperformed actively managed portfolios that rely on market timing and individual stock selection.
Diversification Means Never Having to Say You're Sorry
The incessant noise and information overload we experience every day, which, by the way, can only impact short-term outcomes, does more to distort our reality of the long-view than provide us with any sort of advantage. When applied with discipline and patience, a thoughtfully conceived diversification strategy enables investors to ignore the noise and focus instead on their long-term objectives, which aren't impacted by what the stock market does in the first six months of the year.
By taking a step back to view your portfolio as a whole, and not by its parts, you get a much clearer investment perspective and a reminder of some of the fundamental truths of investing:
- the markets are random—it's impossible to time the market with any degree of consistency;
- risk and returns are related—adding higher-risk elements to your portfolio improves long-term performance, but they are mitigated through diversification;
- and over the long term, a diversified portfolio will yield higher returns while minimizing the risk of any single investment or market segment.
As an investor you need to ask yourself: Would you rather be mildly disappointed that a portion of your portfolio underperformed another, or massively disappointed that you guessed completely wrong by investing in a single market segment at the wrong time?
Craig Slayen is a principal at Cypress Partners., a financial planning and investment management firm in the San Francisco Bay Area.
Pete Woodring, a partner with Cypress Partners, contributed to this article.
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