“An investor’s failure to understand true diversification – to the point where he or she actively wishes to sell the ‘underperforming’ sector in order to chase the winners – is a fundamental aspect of human nature.”
In last month’s article, we discussed why great investors don’t take their chips off the table. This month we focus on the importance of diversification.
As of the close of business on November 7, 2018, the U.S.-based S&P 500 has achieved an impressive total return of 6.9% for the year. In contrast, foreign investment markets have performed poorly, as our preferred benchmark for international equities, The Morgan Stanley Capital International All Country World Index Ex-U.S. (MSCI ACWI Ex-U.S.), has declined by 8.2% for the year (in U.S. dollars). On an overall global basis, the benchmark for global markets including the U.S., The Morgan Stanley Capital International All Country World Index (MSCI ACWI), is also down, but only by 2.5%, thanks to the U.S. market exposure in that index.
Investment advisors and wealth managers everywhere hate years like 2018. Because most investors commonly identify the S&P 500 as their relevant proxy for the equity market, they are having a tough time understanding why their globally diversified portfolios are underperforming this year.
An intelligent investor, one who understands true portfolio diversification, will not only accept the fact that diversification means that they must own asset classes or sectors that are underperforming, they will also embrace that fact.
Diversification in 6 Easy Points
Author Nick Murray eloquently describes our philosophical beliefs about equity diversification in the following 6 easy points:
- Equity diversification divides the invested assets among portfolios with different styles, sectors, and geographical theaters, all of which have historically run on different cycles.
Growth tends to cycle in contrast to value, large cap to small cap, and, as we have seen so vividly this year, U.S. to international/emerging markets.
- The purpose of diversification is to suppress, to some extent, the short- to intermediate-term volatility of the overall portfolio, while earning the full returns of all the components in the long run.
This is usually characterized by people who don’t understand equities as “spreading the risk.” Since I hold that in the long run equities carry no risk, I regard diversification as a method of spreading the short- to intermediate-term volatility.
- In efficient markets, whatever suppresses volatility must commensurately suppress return.
Thus, true equity diversification will always mute the return of a portfolio at any given moment, as it has done this year. This isn’t a flaw; it’s a testament. The investor must keep their eyes on the prize: the full return of all the components over the long term.
- In a genuinely diversified portfolio, something is always “underperforming.”
That’s how you know you’re adequately diversified.
- The last thing on earth a rational investor would ever do is to sell the portfolio components that are already down to buy the ones that are already up.
This would have the effect of destroying diversification. And it isn’t investing; it’s speculating. It’s the very worst imaginable species of performance-chasing.
- If anything, through the wonderful medium of rebalancing, you’ll harvest some of the gains in the leaders in order to reinvest them opportunistically in the laggards.
And the lovely process of diversification will continue to roll serenely on.
Thus, this year has been one of signal vindication for that noblest of equity disciplines. Equity diversification is virtually a character trait. It is a way we manifest the fact that, although we have a very good idea what’s going to happen in the long run, we never know what’s going to happen next. (Nor does anyone else; the difference is that we admit it.)
The Value of Discipline
We have long been believers that discipline is one of the most valuable traits of a Great Investor. When it comes to investing, our definition of discipline is the refusal to react inappropriately to disappointing events, such as times when your portfolio “underperforms” an arbitrary stock market benchmark because it is diversified. It is both the decision not to do something wrong, as well as the decision to continue doing the right things.
An investor who rebalances their portfolio annually should treat these relative performance differences in asset classes as heaven-sent. They provide the opportunity to rebalance more of their capital into asset classes that have been lagging and to “lighten up” on those that have been leading. Buy low and sell high.
Sources: Murray, Nick. Nick Murray Interactive, November 2018, https://www.nickmurraynewsletters.com. Accessed November 2018.