Diversifying When (Especially When) it is Hard

By Michal Emory on October 18, 2018

Michal Emory
I love baseball.  It was always my favorite sport growing up.  Growing up in Houston, all I wanted was to play for the Houston Astros one day.  I played shortstop, so I always had to be #10 just like Dickie Thon who was the Astros’ shortstop at the time.  I was never a home run hitter, but I almost always had a high batting average with plenty of singles and doubles. But, alas, nature won out and my dreams of playing shortstop for the Houston Astros faded.

Nowadays since I cannot play baseball, I love October because it means playoff baseball.  An entire season can be altered by one hanging curveball. One thing that has been very evident the last few years whether it be from the Houston Astros last year or the Kansas City Royals a few years back, is the value of just putting the ball in play.  Back in 2015 when the Royals beat the Astros in a thrilling comeback fashion in the American League Division Series, one thing that really stood out to me was the difference in offensive styles.  

At the time, the Astros hit a ton of home runs but also struck out almost 1400 times as a team. Meanwhile, the Royals were towards the bottom in home runs but struck out fewer than 1000 times—the fewest in Major League baseball. When it came time to put the ball in play, the Royals could, the Astros could not, and that was a key difference in the Royals winning. Fast forward to 2017 and the Astros had the fewest strikeouts in baseball on their way to winning the World Series.  

In investing, as in baseball, there is value in not striking out and “putting the ball in play”.  Having a diversified portfolio is putting the ball in play.  You may not hit a home run like you could if you had all your money in one area, but you are also much less likely to strike out.  So that there is no confusion, here are what diversification IS and IS NOT.

 

As of the end of September, US equities (both large cap and small cap) have been the only source of solid return from an asset class standpoint.  It can be tough to hear about the S&P 500 making all-time highs and not seeing a level of return in your account that would seem to reflect those all-time highs.  
Depending on the aggressiveness of your portfolio, only 10-50% of your portfolio may be in S&P 500 or Dow Jones stocks which dominate the financial news.  If, for example, 25% of your portfolio is made of US Large Cap stocks and the S&P 500 is up 10%, it would be reasonable to expect that portion of your portfolio to be up around 2.5%.  But, if the S&P 500 is down 10%, you could expect that portion of your portfolio to only be down around 2.5%.  Diversification is giving some of the upside of an asset class to not fully participate in all the downside. But as we are about to see, that does not mean your portfolio cannot still have great returns over the long-term.

The table below is how a generic 60% equity/40% fixed income portfolio has done since 1970.  The Diversified Portfolio has a combination of US Large Cap Equity, US Small Cap Equity, International Developed Equity, Emerging Markets, US Fixed Income, and International Fixed Income.1  The US Portfolio has US Large Cap, US Small Cap, and US Fixed Income only.  I have added in the S&P 500 to compare how a diversified portfolio matches up versus a US-only stock portfolio. Returns are since 1970.

The Diversified Portfolio has higher returns and less volatility than the US Portfolio. In fact, the return on the Diversified Portfolio is not far off from the return of the S&P 500.  And again with significantly less volatility.  Interestingly, the Diversified Portfolio outperformed the S&P 500 in three out of the five decades.  If we look at rolling 10-year periods, the Diversified Portfolio has outperformed the US Portfolio 62% of the time.  As one would expect, markets go through phases where the Diversified Portfolio outperforms and some where the US Portfolio outperforms.  As you can see below, we have been in a long trend where the US Portfolio has been outperforming but there is no guarantee on how long that will persist.

 

 

Some may be thinking “I know that I need fixed income but why do I need International exposure?”  The answer is because International Equity has a low correlation with US Equity, providing another source of return during periods when the US stock market is dragging.  There can be long periods where the US stock market moves sideways or down.  The chart below shows a comparison of US Equity (90/10 Large-Small) portfolio and a Diversified Equity (70/30 US-Int’l) portfolio.

 

 

Once again, we can see that a diversified equity portfolio provides greater return for less volatility.  The 2000s was a down decade for the S&P 500.  A diversified portfolio could have saved an equity portfolio from potentially experiencing a down decade also.  Below is look at how the MSCI EAFE (the main international equity index) has fared versus the S&P 500 over a rolling 12-month period since 1970.

 

 

Even though diversification works over time, there will always be times when we want to cast diversification aside.  2018 has certainly been one of those years.  It can be tempting during these times to throw your plan out the window and think that our present circumstances will continue indefinitely.  But as we have seen in the start of October, the market’s mood can change quickly, and the best defense is being properly diversified.  There is only one sure thing when it comes to investing.  And that is that markets will fluctuate and “what works” will change seemingly with the seasons.

I cannot tell you whether the start of October is a mere hiccup or a signal of a top.  But I do know that the best way to face the uncertain future is with a portfolio diversified enough to weather many types markets and reduce the chance of a life-altering loss.  A market trend can continue longer than one would think is possible but ask yourself a simple question.  Is it more probable that we get another decade of US equity outperformance relative to International equity or is it more probable that there is a reversion and International equity outperforms?  I would wager that a reversion is more probable.  But since I do not, nor does anyone else, know, the prudent course is to stay with a diversified portfolio. 

I hope this answers some questions on why it is important to stay diversified even if (especially if) we are in the middle of a year where it is tough to stay diversified.  At The Trust Company, we count it a privilege to be a part of your financial journey.  We look forward to continuing to help you meet your financial goals.

 

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