Is Diversification Dead?

2018 has been an interesting year for markets.  While US growth stocks have continued to push US stock indices higher, most other markets have actually fared quite poorly. For example, international stocks, emerging market stocks, bonds, and gold are all negative for the year.

Exhibit 1 – click to expand

Unfortunately, this means that if you own a ‘balanced’ or ‘diversified’ portfolio you may be flat or even down slightly for the year.

Interesting as well is the substantial and continuing outperformance of US growth stocks relative to US value stocks. We’ve noted before that this growth stock outperformance is very long in the tooth and likely to reverse over time.

Exhibit 2 – click to expand

Does this mean diversification is dead? Should an investor simply go “all in” on US growth and shun other investments? Quite the contrary.  We believe diversification today is more important then ever before.  And the reason can be summed up in one word: risk.  While it is great to watch a portfolio grow in value and assume that it will continue to do so year after year unabated, the market tends to run in cycles. Oftentimes these cycles run to extremes both up and down.  When evaluating a portfolio mix its important to consider how much risk you are willing to take (or have the capacity to handle).  One way to think about it is to ask yourself, “If my portfolio went down, how much would I be willing to lose before I would start to panic?”  Or, “how much of a decline would dramatically alter my financial plan/objectives?” Many don’t know this answer and there is no right are wrong as each investor’s goals, objectives and time horizons are different, but we think it is a worthwhile exercise.  While it has been a tremendous cycle for the US stock market, at these levels we believe investors should both temper expectations given current valuations.

Exhibit 3 – click to expand

The chart above is the “Shiller PE Ratio”, a ratio of the price of a share of earnings of the S&P 500 relative to the earnings for that same share averaged over a 10 year period.  As you can see we are at the second highest level ever seen.  The highest?  The tech bubble which burst in 2000.  The S&P fell over 40% over the next 3 years before bottoming out in 2003.  As you can see it was also at elevated levels in 2008 prior to a roughly 37% decline.  Now this isn’t to say the market can’t go higher and we are certainly not predicting anything over the short term.  In fact, the market could go a lot higher from here.  The point is at these levels, performance is not likely to live up to expectations and is much more likely to disappoint.  So what to do?

First off, re-evaluate your goals.  If your primary goal is to try and beat or even track the stock market every year then you can stop reading here.  But if you’re like most investors we meet and your goal is to provide reasonable risk adjusted returns, then investing in just one asset class doesn’t really fit your objective.  We believe that you should remain (or get) well diversified.  And diversified doesn’t mean owning 100 stocks or 5 mutual funds that all own stocks.  It means constructing a portfolio that contains many asset classes including some with very little correlation to stocks.  So that when the next downturn assuredly comes you have some investments that hold their value and may even make money to offset the riskier investments in your portfolio.  It also means looking to other markets that may be “cheaper” and therefore more attractive over the intermediate to long term, thereby diversifying your stock portfolio globally as well.

This approach is not always exciting and will rarely ‘beat’ the market over shorter periods of time but it helps you reduce risk, reduce volatility (that is the amount and frequency of fluctuation in your portfolio) and may put you in place to recover sooner from a market decline.  Moreover you can start to see declines for what they are; opportunities.  When viewed through the correct lens, one might even look at Exhibits 1 and 2 and recognize that perhaps today’s opportunities lie in the assets which have underperformed the most this year.  We certainly think so.

In summary while not very sexy and sometimes frustrating, diversification still provides many benefits, the greatest being peace of mind.  Thanks for reading!

About James Dwyer, CFP®, AIF®

James Dwyer has worked in the financial services industry for over 15 years. He is currently a partner at Providus Advisors, an investment advisory firm located in Chandler, AZ.

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