The Diversification Conundrum

Are you feeling lousy about your 2014 investment returns? Me too! Let’s take a stroll down memory lane and review what happened last year.

Typically, clients only hear about “the market” — or the S&P 500 as we advisors call it. It’s the benchmark for news outlets and magazines to write about and report on. According to Investopedia, the S&P 500 (or more formally, the Standard & Poor’s 500 index) is “an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.”

Wall Street in the news

So, you’ve probably heard the news about how the S&P 500 was up last year. It’s true, the popular index was up 13.66% in 2014 which is very impressive but let’s hold on just a second. The trailing 10-year average is 9.49%. What does this mean? Well, it’s pretty simple, last year the S&P 500 outperformed its 10-year average by nearly 50%! While it’s nice to outperform, you need to take that double digit return with a grain of salt. And why is that? Because U.S. equities are just one component of a truly diversified portfolio and that’s why your portfolio might not have performed as well as the S&P 500.

Compare the S&P 500 to other asset classes

Let’s take a look at a few other asset classes so we can draw a comparison. International equities by contrast were down 4.90% in 2014 — that’s a negative 4.9% — with a 10-year average of 10.05%. High yield bonds returned just 2.45% in 2014 while boasting a 9.43% 10-year average. And last but not least, senior loans — which are also known as floating rate notes — were up a measly 0.57% in 2014, and averaged 5.10% over the past 10 years.

Source: Lipper Inc.

That was very technical, I know, but I hope you’re still with me!

Why pick on these asset classes, you ask? Because they are tools we use in many client portfolios to provide sources of return, income and of course, diversification. Not to mention the fact that international equities provided the least in terms of asset class performance, yet still had a higher 10-year average return than the S&P 500 and all the other asset classes I just discussed. High Yield bonds provided income and diversification but a paltry 2.45% total return. Its 10-year average return at 9.43% is almost indistinguishable to the S&P 500. Lastly, senior loans provided us with their second lowest returns over the past 10-years.

Unfortunately, diversification can sometimes hurt portfolio returns. It’s particularly stark when the S&P 500 outperforms its 10-year average like it did last year. What makes matters worse is that the underperformers don’t come anywhere near their 10-year averages.

The bright note? Many portfolios have more allocated to U.S. equities (in general) than any other asset class, and the fact that U.S. equity outperformed its 10-year average managed to keep portfolio returns positive.

It’s about “Time in the Market” not “Timing the Market”

The U.S. market is currently at an all-time high and there might be a better buying opportunity in the future. Shifting your portfolio to U.S. equities would effectively be like selling low and buying high. Think of it like this: you would be selling an asset class that is below average in order to buy another that is above average. In fact, the S&P returned well above average in not only 2014 but also in 2012 and 2013. We all know the ultimate goal of investing is to buy low and sell high. So why would you want to do that?

What I do suggest is that you remember the adage “what goes up must come down.” At some point, the assets that did poorly last year may come back to their average and your portfolio’s return will benefit. Most of our clients complete — what we refer to as — a risk tolerance questionnaire (RTQ). The RTQ allows us have a better understanding of your view of the investment world. Are you risk averse, meaning you would like to play it safe? Are you aggressive, which means you’re probably OK with riding the ups-and-downs of the market? Or are you somewhere in between? If you haven’t completed a risk tolerance questionnaire recently you can answer ours by clicking here. Once you’ve answered all the questions, a customized report will automatically be sent your e-mail address.

I hope you enjoyed this post. If you have any questions or comments please feel free to leave them by commenting below.

Disclosure:

The opinions voiced in this article are for general information only. They are not intended to provide specific advice or recommendations for any individual and do not constitute an endorsement by LPL. To determine which investments may be appropriate for you, consult with your financial professional. Investments are inherently risky and will fluctuate with changes in market conditions. Indices are unmanaged measures of market conditions. It is not possible to invest directly into an index. Past performance does not guarantee future results. Diversification does not guarantee profit nor is it guaranteed to protect assets. In general the bond market is volatile. Fixed income securities carry interest rate, inflation, credit and default risks. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. The MSCI EAFE Index serves as a benchmark of the performance in major international equity markets as represented by 21 major MSCI indexes from Europe, Australia and Southeast Asia. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and differences in accounting methods.