Recently, LPL Financial published a Thought Leadership piece discussing the many benefits of diversification. It highlighted the fact that, so far this year, we have seen that a diversified portfolio has benefited investors. However, that has not always been the case in recent years. Historically, we have seen that diversification typically alternates between several years of being beneficial for investors and several years of being negative for investors, but the important point is that the benefits of diversification are positive in the long-term.[i] Given the patterns we’ve witnessed in 2016, it looks like we are on track for a period of diversification benefits once again.
The full Thought Leadership piece published by LPL Financial can be accessed by clicking here. But we want to spotlight a few key points.
Lack of diversification can have consequences. When investors get caught up in the asset class du jour, they may be inclined to be less diversified in their investments, opting for more concentrated strategies. But, as LPL notes, this approach can be dangerous. Investors become too focused on the upside of an investment and become too nervous when they’re not doing well (because they realize they are taking on too much risk), so they engage in “panic selling” to try to avoid losing money. But in the long run, it can cause them more loss than if they had stuck it out for the long haul. As an example, you may remember the “dot-com bubble,” where the stock markets saw equity values rise rapidly from the growth in the internet sector, and then crash just as quickly. This created an environment where many investors were, first, too confident in technological advancements and, essentially, placed all their eggs in one basket. Then, when their investments lost value, many investors hastily reacted to the situation and tried to cut their losses by taking their money out of those dot-com stocks. Sometimes, those stocks did well, and sometimes those stocks performed dismally. Better yet, a principled approach to a diversified portfolio often helps an investor sidestep these dilemmas altogether.
LPL noted that “investing solely in information technology (represented by the S&P 500 Information Technology Sector Index) beginning in 1998 would have netted over 200% cumulative excess returns by the end of March 2000, relative to the S&P 500.” But, by the end of September 2001, only a year-and-a-half later, that sector lost all relative gains and some, underperforming the S&P 500 by -9.1% cumulatively. It also experienced over two times the volatility of the S&P 500.
Another example provided by LPL was the housing bubble that occurred in the 2000’s, which had a similar narrative to that of the technology bubble. For about four-and-a-half years, the housing industry (as represented by the S&P 500 Homebuilding sub-index) outperformed the S&P 500. But, starting in July 2005 and for two-and-a-half years following, its performance declined. Ultimately, it underperformed the S&P 500 over the period of January 2001 through November 2007.
There is no certainty in performance. Even with the availability of historical performance statistics, there is no way to determine with assurance how an asset class will perform. As LPL demonstrated, sectors that have performed well over the previous five years, have historically not performed well over the next five years. So choosing a specific asset class to invest in based on its history has just not been an effective approach. Moreover, diversification seems to add more value the longer it is exercised.
LPL illustrated the long term benefits of a diversified portfolio by explaining that diversification may provide a benefit over 50% of the time on a one-year rolling basis, but that number improves to 63% over a five-year rolling period and 100% over a twenty-year rolling period. The longer the period, the better it works.
Don’t lose focus of the global market. Some investors seem to forget that there are other markets in the world worth investing in. In fact, U.S. equities make up only about 54% of the “global investable universe,” as LPL put it. That leaves 46% of possible investments being left out if you’re ignoring the global market. Effective diversification might mean considering foreign and emerging markets, particularly since they are earlier in their economic cycle than the U.S. All investments have risks involved, global markets included, but it’s important to remember that foreign and emerging markets can add opportunities for return enhancement to one’s portfolios.
The bottom line is that we need to remember that diversification often requires a long-term commitment. It may not always feel right or look right (particularly, in the short term), but when observed historically, we continue to believe in a diversified portfolio.
We encourage our clients to maintain a diversified mindset if you are looking for long-term strategies. If you have any questions about your investments or would like to review your portfolio, please give us a call.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Stock investing involves risk including loss of principal. Indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advisory services offered through CWM, LLC a Registered Investment Advisor. LPL Financial is under separate ownership from any other named entity.
[i] “Diversification” here is defined as the following indexes: 30% S&P 500, 20% Russell 2000, 20% Russell Midcap, 10% MSCI EAFE Index, 10.0% FTSE Nareit Equity REITs, and 10.0% MSCI Emerging Markets (Net). The results of this analysis are hypothetical and provided for illustrative purposes only. Had different indexes been used the results would also have varied. The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The Russell Midcap Index offers investors access to the mid cap segment of the U.S. equity universe. The Russell Midcap Index is constructed to provide a comprehensive and unbiased barometer for the mid cap segment and is completely reconstituted annually to ensure that larger stocks do not distort the performance and characteristics of the true mid cap opportunity set. The Russell Midcap Index includes the smallest 800 securities in the Russell 1000. The Russell 2000 Index measures the performance of the small cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. The MSCI Emerging Markets Index is a free float-adjusted, market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI EAFE Index is a free float-adjusted, market-capitalization index that is designed to measure the equity market performance of developed markets, excluding the United States and Canada. The FTSE NAREIT All Equity REITs Index contains all tax-qualified REITs with more than 50% of total assets in qualifying real estate assets, other than mortgages secured by real property that also meet minimum size and liquidity.