In Defense of Diversification
Now in the tenth year of the current bull market, the longest in history, we are beginning to hear investors question the benefits of diversification as stocks have risen steadily, with few interruptions, since March 2009. In the language of behavioral finance, this skepticism is attributable, in part, to what is known as recency bias, or the tendency to expect recent trends and conditions to remain in place indefinitely. For some, the pain of the financial crisis, and the damage it inflicted on investment portfolios remains fresh in their minds. For others, the crisis has been relegated to the history books, an anachronism in today’s investment landscape.
A few simple examples may help to illustrate the benefits of diversification. Those with longer memories recall vividly that between October 2007 and March 2009 the S&P 500 fell 57 percent. They likely also recall that the Bloomberg Barclays U.S. Aggregate bond index rose by 7 percent during that same interim. A simple portfolio, diversified equally between these two asset categories, would have resulted in a loss of 27 percent. Painful to be sure, but not the financial disaster that an undiversified exposure to the S&P 500 alone would have inflicted. Yet we are now once again beginning to hear the voice of frustration with diversification, as the crisis fades further into memory. Investors see stock prices continuing to rise and feel left behind. They compare their own portfolio performance to the best performing asset category and wonder why they are not enjoying the same high returns as the neighbor who talks only about his winners, but never his losers.
Through the first three quarters of this year, the S&P 500 was higher by 9 percent in price terms. The Bloomberg Barclays Aggregate Bond index was down 1.6 percent, leaving that simple, diversified portfolio higher by 3.7 percent. To those who remain mindful of the importance of diversification, the simple portfolio is behaving as intended, with half the volatility of the S&P 500. To the amnesiac, that diversification is acting as an impediment to wealth creation, and their frustration grows.
From the trough in equity prices in March 2009 through October 17 of this year, the S&P 500 is higher by 315 percent in price terms. During that same time period, the Bloomberg Barclays Aggregate Bond index is higher by 39 percent. The skeptic would offer that 276 percent outperformance as proof that diversification is a barrier to wealth creation. However, that cherry picked time frame is self-serving, as it avoids the prior downturn in stock prices during the crisis. If we do the same calculation from the previous peak in the S&P 500 before the crisis in October 2007 the story is quite different. The price return of the S&P 500 since then is 79 percent, better than bonds as expected, while the return of the Bloomberg Barclays index is 49 percent. First, note that the performance disparity between the two asset categories shrinks dramatically, to 30 percent. But this simple exercise illustrates the second benefit of diversification, namely lower portfolio volatility. An all stock portfolio from October 2007 would have delivered a total return of 79 percent, but with average annual volatility of 24 percent, as measured by the standard deviation of returns. The simple blended portfolio would have delivered a total return of 64 percent, but with a standard deviation of 9.6 percent, 60 percent lower. The blended portfolio delivered a performance that was demonstrably less anxiety inducing, likely mitigating the risk of making an emotionally driven decision that would have been counterproductive, including possibly exiting the market altogether and missing the subsequent recovery.
In some respects, the concept of diversification is similar to insurance. No one likes to pay the premium for life insurance, but who wakes up every day upset that, once again, the policy did not pay off? The peace of mind that comes from simply having that policy in place, knowing that one’s family will be well taken care of, is comfort enough, and worth the price of the premium.
Which brings us back to today. No one knows when the current bull market in stocks will end. But we do know that someday it will. It is already the longest in history. But we are beginning to see on the horizon some early signs that the current environment is likely to become more challenging. The Federal Reserve is raising interest rates to prevent the economy from overheating, slowly tightening financial conditions. The U.S. economy is currently enjoying a growth spurt as a result of fiscal stimulus. But that stimulus is expected to diminish toward the end of next year, and the economy will likely slow along with it. At the same time, corporate earnings growth has surged, contributing to higher equity prices. But earnings growth is expected to decelerate next year to perhaps half of this year’s pace. And global economic growth also appears to have peaked, as evidenced by the recently lowered forecast from the International Monetary Fund. All of which may suggest that we are closer to the next point in time when the merits of a well-diversified portfolio will once again prove themselves.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.
Past performance is not a guarantee of future results.
The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.
The Bloomberg Barclays Global Aggregate Bond Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
Diversification does not assure a profit or protect against loss.
The information and opinions in this article are compiled from third party sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Ameriprise Financial. The information is not intended to be used as the sole basis for investment decisions, nor should it be construed as advice designed to meet the particular needs of an individual investor.
Indexes are unmanaged and are not available for direct investment.
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- Chief Market Strategist, Ameriprise Financial
- More than 30 years of experience in the investment management industry
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