“Don’t look for the needle in the haystack. Just by the haystack!”
– Jack Bogle
Learning to Love Diversification
At Financial Coach, we build and use diversified portfolios for our clients, it’s a key pillar of our core investment philosophy.
Proper diversification is a powerful and sensible investing practice. So why does it sometimes feel so uncomfortable? Our investing brain is wired to make comparisons to the best performing assets, and make us wonder why we didn’t own more of them than we did. We also can’t resist asking ourselves why we had the losers in our accounts at all, and by the way, shouldn’t we be selling out of them?
These impulses are what can cause us to do exactly the wrong thing, at exactly the wrong time. For example, Bonds and REITs (Real Estate Investment Trusts) were two of the worst performing asset classes in 2013, but led the way in 2014. A year ago, had we given way to the temptation to sell those and buy the best performers at the time (small cap stocks), we would have been worse for the wear.
And in 2014, large cap U.S. stocks (measured by the S&P 500) returned over 13% for the year, making it one of the best performing asset classes in the world. By comparison, international stocks (measured by the MSCI EAFE index) were down nearly 5% for the year. It would be a mistake to extrapolate very recent events into the future, but that’s just what many people do.
Let’s remember why we diversify:
– It reflects an understanding that nobody can predict the winners and losers over short time periods, so making bets on or against an asset class is nothing more than speculation and guess work.
– Great returns in one year on an asset class do not in any way predict returns in the next. In fact, the higher the returns today, the lower the expected returns are for the future, and vice versa.
– Reducing overall volatility and smoothing out returns over time is a good thing, particularly for those in or nearing retirement.
By definition, a diversified portfolio will under-perform the best performing constituents within it. It will also outperform the worst ones. It’s important to realize that in most market conditions, we should want to see a variety of returns on the individual investments in our accounts. First, it’s an indication that we are in fact diversified; and second, it provides opportunities to rebalance and employ the discipline of buying more of what’s cheap and selling what’s more expensive.
None of this is easy, by the way. Emotions always come into play and tempt us to become our own worst enemy. This is the behavioral piece that you hear us talk about constantly. Our advice is to trust the process and the evidence! Changes to your overall investment strategy should be driven by changes in your own personal situation, goals, tolerance for risk, a life event, and such. Stick to the plan and resist the urge to tinker based on market events or the headlines of the day.
As always, thank you for your trust and confidence in us. Your feedback is always welcome.
Michael Traynor CFA®
Chief Investment Officer