We have just completed the third quarter of the year, and stocks have rallied in recent months to “all-time highs!” In fact, the third quarter was the best quarter for the stock market since 2013. So, why is your portfolio not up 10%, like the Dow or the S&P 500?
This is a common question from our clients, especially in a market that is being driven convincingly by only one asset class. The answer is simply that at Concentus Wealth Advisors, we value diversification, which Investopedia defines as “a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.” The important part of this definition is that you may achieve higher returns with less risk if you diversify your portfolio.
Unfortunately, the financial news media does us no favors because it ignores the concept of diversification. The media typically focuses solely on the U.S. stock market, but U.S. stocks make up only 40 percent of the market capitalization of global equities. And while the U.S. has been having a good year in terms of stock appreciation, the rest of the world has not experienced the same good fortune. Here are the year-to-date returns in 2018 for the “other” asset classes:
- Developed International Stocks are down (1.0%)
- Emerging Market Stocks are down (7.7%)
- Commodities are down (2.0%)
- Fixed Income is down (1.6%)
- REITs are the only other broad asset class that is up on the year (a scant 1.8%)
The chart below, from J.P. Morgan, displays the annual returns of investable public asset classes over the last 15 years.
There are several observations to be made when viewing the chart. Here are a couple that stand out to us:
- From 2010 through today, U.S. stocks, large and small, as well as REITs (another U.S.-centric asset class consisting of real estate) have been at the top, or near the top, of the charts.
- From 2003 through 2009, emerging markets and developed international markets were at the top, or near the top, of the charts.
- The variation of returns between asset classes are often significant, sometimes to the magnitude of a 40-50 percent difference.
- Asset allocation (a weighted index of all asset classes) has always remained safely in the middle of the pack, as shown with the connecting lines.
One important note that cannot be observed in the chart is that no one knows which asset classes will lead and lag from one year to the next. Hindsight might lead us to believe that we can predict what market will lead the others, but don’t kid yourself – no one knows! This is important because, absent a crystal ball, we are not able to pick and choose the future winners and losers each year.
As prudent investors, the only choice is to follow an asset allocation strategy. Admittedly, we do not have a crystal ball, nor do we practice witchcraft. But owning a diversified basket of assets is as close to wizardry as we will ever come. I’ve included the following chart to reveal the magic of diversification:
As you can see, Portfolios 1 and 2 are dramatically different investments and move in opposite directions, similar to the chart we reviewed above. Portfolio 1 is made up of U.S. stocks. Portfolio 2 is made up of ten-year U.S. treasuries. Knowing that you cannot predict which asset class will perform best from year to year, a better choice would be to own Portfolio 3, which invests 50 percent in both Portfolio 1 and 2. The effect is that Portfolio 3 displays less volatility and has performed, at times, better than either portfolio. By diversifying your holdings, you may achieve higher returns than either asset and reduce your overall risk.
This phenomenon is also evident in studying the sequence of returns because, after all, not all returns are created equal. That is, it is possible for two investors with the same average return to have vastly different results. The investor that has more money in the end would also typically be the same investor that had less-volatile returns, enjoying a smoother ride. Meanwhile, the investor with large return variations from one month to the next may not have as much money, due to large draw-downs. Most importantly, the investor experiencing large variations is likely more susceptible to making bad behavioral decisions, which is highly detrimental to their investment plan. Don’t follow suit! We have published the pitfalls of bad investor behavior in our Great Investors Article Series; if you want to become a great investor, be sure to follow along.