There’s an expression in my industry around diversification. It is along the lines of – “Having a client properly diversified means always having to say you’re sorry.” The basic premise is not all asset classes move in the same direction, at the same pace, at the same time. Hence, if I have done my job some of your investments will be moving up while others may lag, or even be moving in the other direction. I guess some clever advisor thought this meant an advisor should apologize for doing right by the client. Seems illogical to me, but what do I know.
The concept of diversification is to spread out your investments which then decreases the overall risk of your entire investment portfolio. Listen, right now being properly diversified is boring. The S&P500 has been setting all-time highs. I heard recently it has been over 300 trading days since the last 5% correction in the market, which is the fourth-longest streak in the history of the index. I shared recently how every asset class, except commodities, is up this year. No one wants to be diversified when everything is going up. But what about once we break that 5% streak?
Nobel Prize winning economists Kahneman and Tversky proved something we all probably knew existed – we hate losing more than we love winning. But I won’t be Debbie Downer here. I’m sure you have heard all about how diversification protects you on the downside. But, what about the upside? (Insert my Shamwow infomercial voice here) Is that even possible? Well, let’s see how diversification can help you even when a market is rising!
I’ve referred to the book A Wealth of Common Sense on multiple occasions. Ben Carlson is constantly putting out great content. One example he shared looks at the performance of three asset classes from 1970 to 2014. Annualized returns during this period were 10.5% for European stocks, 9.5% for Pacific, and 10.4% for US stocks. These are great results and nothing anyone should complain about. But wait, there’s more!
What happens when you create an equally weighted portfolio of these three holdings and rebalance to their original even weightings the end of each year? You’re probably thinking – “But Dan, can it get better?” Suddenly the annualized return is 10.8%! In this case, three winners are following a proven strategy – rebalancing by selling high and buying low. Each of these three asset classes had good years and bad years. By following a disciplined investment rule of rebalancing at the end of each year their overall returns increased above what any individual asset class averaged over this same time period.
This data reminds me of one of the comments I shared in the recent market commentary. In that case it was a 60/40 stock to bond portfolio over the last 20 years. While I wouldn’t describe this portfolio as highly diversified, the data reinforces the importance of rebalancing – higher returns, lower volatility and a better risk-adjusted performance.
I’m not going to remind you about why you need to diversify. The common theme shared by most advisors is diversification helps protect you on the downside. Well, you know I am not like most advisors. You sure don’t need a lecture on something you already know. My point is to show you how diversification, rebalancing, and following a discipline will help you on the upside too. And in those cases I will never say, “I’m sorry.” Oh, and if you want to stump the average advisor, feel free to ask them how diversification helps on the upside.