Diversification works, even when you don’t want it to.

We preach proper diversification as the foundation for constructing a prudent portfolio.  By definition, diversification means to distribute among different companies or investments to minimize the potential for loss. We believe successful investing means not only capturing reliable sources of expected return but also managing avoidable risks, such as holding too few securities, betting on countries or industries, following market predictions, speculating in areas like interest rate movements, etc.  Spreading your investments across different types of assets is one of – if not the ­– best way to avoid these risks.  And though diversification does not eliminate the risk of market loss, it does help eliminate the random fortunes of individual securities while positioning your portfolio to capture the returns of broad economic forces.

We’re used to watching certain asset classes perform well in a given time period while others underperform significantly.  That’s OK.  That’s what we sign up for when we put together an investment portfolio with multiple asset classes that don’t move in lock step with one another.

It can be very frustrating, however, to have a year like 2013, when the US large cap stock market (as represented by the S&P 500 Index) does really well and not see your portfolio perform in a comparable fashion. As of the mid-point in the year (6/30/2013), the S&P 500 was up about 14%, while other asset classes that are held in well diversified portfolios were up much less (or posted negative returns).  For example, here are some commonly used asset classes and their 2013 performance through June 30th:[i]

  • International Large Cap Stocks: +4%
  • Emerging Markets Stocks: -9%
  • Real Estate: +1%
  • Foreign Bonds: -7%
  • US Short Term Bonds: -0.50%
  • US Inflation-Protected Bonds: -7%.

Why do we believe in holding these other asset classes at a time when the US large cap market is chugging along so nicely?  Well, we know that will not always be the case. And when these other areas come back into favor we’ll want to experience their returns.  In the meantime, we’ll rebalance portfolios when they are underweight in these areas, looking to “buy low.” It may seem counter-intuitive to reduce your exposure to things that have done well recently and buy things that haven’t, but this disciplined strategy leads to lower volatility over time and potentially higher returns.

Here is a great chart, courtesy of Morningstar, that illustrates the fact that there is no pattern to future market returns, other than the fact that asset classes that do well will eventually fall to the bottom of the pack and vice versa.  This chart shows how a sampling of asset classes performed, year by year, in descending order.  Notice how the diversified portfolio (in gray) never leaves the middle.  We strive to achieve these consistent and meaningful returns in our portfolios, even if it means being out of favor at times.  Right now the US large cap stock market is in favor while most other areas are performing below their historical norms.  That’s ok, because we know that diversification ultimately works.  Even if we don’t want it to right now.

Click on the graph to see it in a larger view.

Click on the graph to see it in a larger view.

If you have any questions about investment management or how the professional financial advisors at Woodward Financial Advisors are constructing your portfolio, please let us know.  We’re here to serve you.


[i] Index data used:  International Large Cap stocks MSCI EAFE, Emerging Markets MSCI EM, Real Estate MSCI World REIT, Foreign Bonds Citi World Bond, US Short Term Bonds Barclays 1-5 Year, US Inflation-Protected Bonds Barclays US TIPS.

About Jim Miller

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