Diversification in the 21st Century

It is often recommended that only long-term money should be placed into the equity markets, since outcomes can vary widely in the short-run.

— Mark Meredith

Financial Consultant, Wealth Management / Brokerage
TheBANK of Edwardsville

The definition of a longterm investment can differ depending on with whom you are speaking. Even amongst the greatest investors, opinions vary greatly. George Soros may consider a long-term investment a year or two, while Warren Buffett is looking to hold on 15-20 years or more. Neither Soros nor Buffett are a good comparison for most individual investors, as they have a different set of goals than many of us. While they are trying to achieve excess performance for their investors, many of us are trying to save, invest, and preserve money for retirement that will last for the remainder of our lives. If you believe you have a skillset similar to Buffett or Soros, please do not continue reading (also send me your historical returns).

With the strong recovery from The Great Recession in U.S. markets, some have started to question the benefits of diversification. Below I have inserted a table showing the investment returns of different asset classes for the first decade of the century, the returns so far for the second decade, and the returns of the full period.

Asset class

Annualized return from 01/01/2000 – 12/31/2009

Annualized return from 01/01/2010 – 11/30/2016

Annualized return from 01/01/2000 – 11/30/2016

U.S. Large Cap1 -0.95% 12.68% 4.41%

U.S. Small Value2

7.68% 14.81% 10.53%

Foreign Developed3

1.58% 3.82% 2.49%

Foreign Emerging4

9.41% 0.90% 5.84%

U.S. Real Estate5

10.66% 13.03% 11.62%

U.S. Bonds6

6.33% 3.65% 5.22%

The table shows how diversification can work. I think many investors would consider 10 years a long time horizon. If you had been concentrated in just U.S. large cap stocks, the period from 2000 – 2009 would have felt like an eternity. Adding the other components to your portfolio would have shown improvements. U.S. bonds will likely continue to be a good diversifier against equity risks, but it is unlikely that they will generate returns similar to the last 15+ years. Let us look at the returns of a portfolio below that is split evenly between the 5 equity classes from table one (15% in each of the first 5) and 25% in U.S. Bonds.

15% in each with 25% in bonds

Annualized return from 01/01/2000 – 12/31/2009

Annualized return from 01/01/2010 – 11/30/2016

Annualized return from 01/01/2000 – 11/30/2016

Portfolio

7.14% 8.05%  7.51%
*This assumes the portfolio is rebalanced to the original weights annually. Return data is from Morningstar Advisor Workstation.
*This is a hypothetical example for illustration purpose only and does not represent an actual investment.

If you look at just the individual pieces from the first table, returns can vary widely between asset classes. Combining a portfolio with different groups of investments has helped smooth out the returns historically and dampen volatility. The first decade of the 21st century, I would imagine most people would have been pleased with their diversified portfolios. Returning
7.14% annually while the S&P 500 earned -0.95% is something people would brag about to their friends. Earning 8.05% while the S&P 500 earned 12.68% is a little less gratifying, and somewhat aggravating. Emerging Markets, which helped significantly in the first decade, have been detrimental in this one. The bottom line return of a diversified portfolio is not enormously different though. The memories investors have of their diversified portfolios working in decade 1 are starting to fade, and some are starting to improperly compare their returns to the S&P 500. If you own anything outside of large cap U.S. stocks, the S&P 500 is not a proper benchmark. Your benchmark should be in line with your investment goals.

If we step back and view the full period from 01/01/2000 until the end of November this year, an annualized return of 7.51% is still considerably better than investing in just U.S. Large Cap stocks. There will be long stretches of underperformance though and people will consider dumping foreign stocks at a time like this, which I believe would be a BIG mistake. Time will
tell. I urge investors to focus on the bottom line of their portfolio, and not how each individual piece is doing. You will usually have areas that are underperforming, and areas that are outperforming. If you stick with a well-diversified portfolio over a long period, it is nearly a certainty that your total portfolio’s return will fall in between the best performing asset class and the worst.

There is little doubt that U.S. equities are on the expensive side of historical valuations, which should tell investors to anticipate below average returns going forward. This does not mean the market has to crash. On the flip side, many non-U.S. equities are within their average valuation range and some are even well below. This would cause me to anticipate higher than average returns looking forward. No returns are guaranteed though, which is why it is important to consider diversifying, rebalancing, and harvesting tax losses. As you know, I find predictions about financial markets, economics, politics, and life useless. Below I have included a list of items that I think very few people forecasted happening in 2016:

  • The Dow Jones index would gain close to 4,500 points from the February low, reaching over 19,900. (Remember 15,600 Dow in February?)
  • Donald Trump would win the election.
  • The stock market would do well after the election.
  • 1 of 2: The Chicago Cubs and Cleveland Indians would battle it out for the World Series title.
  • 2 of 2: The Chicago Cubs would come back from a 3-1 deficit in the World Series.
  • The stock market would do well after the Cubs victory (I thought the world was ending myself).
  • The UK voting for the Brexit, and the stock market would do well after the Brexit vote.
  • The average national price for a gallon of gas would fall under $2.
  • The price of oil would be up nearly 100% from the February lows.
  • The dollar would continue to strengthen against other major currencies.
  • Low inflation would persist.
  • Interest rates would reach another all-time low during the year.
  • Villanova would win the NCAA basketball championship.
  • The Cleveland Cavaliers would come back from a 3-1 deficit in the NBA Finals to beat the Golden State Warriors who set the all-time single season wins record.
  • The St. Louis Rams would relocate to Los Angeles (just kidding we saw that one coming!).
  • Warren Buffett would invest in airlines (after previously saying: “The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”)

 

1. Index used is the S&P 500 Total Return Index.
2. Index used is the S&P SmallCap 600 Value Total Return Index.
3. Index used is MSCI EAFE Gross Return Index.
4. Index used is the MSCI Emerging Markets Investable Market Index Gross Return.
5. Index used is the Dow Jones US Select REIT Total Return Index.
6. Index used is the Bloomberg Barclays US Aggregate Bond Total Return Index.This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of Mark Meredith and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Diversification does not ensure a profit or guarantee against a loss. Be sure to contact a qualified professional regarding your particular situation before making any investment or withdrawal decision. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. The MSCI Emerging Markets is designed to measure equity market performance in 25 emerging market indexes. The index’s three largest industries are materials, energy, and banks. The Barclays Capital Aggregate Bond Index is a market capitalization weighted index. The index includes treasury securities, government agency bonds, mortgage-backed bonds, corporate bonds, and a small amount of foreign bonds traded in U.S. Dollars. The MSCI EAFE (Europe, Australia, and Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States & Canada. The EAFE consists of the country indices of 22 developed nations. The Dow Jones U.S. Select REIT Index intends to measure the performance of publicly traded REITs and REIT-like securities. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary. Inclusion of these indexes is for illustrative purposes only. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, Certified Financial Planner™ and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
  • Mark Meredith
    • Financial Consultant,

    • Investment Services
  • TheBANK of Edwardsville
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