Diversification is one of the basic rules of investing and is also a critical way advisors add value to client accounts. Yet over the last decade, and particularly over the last year, many clients have lost faith in diversification as a risk management strategy. The main reason is the dominance of U.S. large cap stocks in the most recent 11-year bull market. The fact is, from 2009 through 2019 investors with diversified portfolios underperformed those who simply invested in the S&P 500® Index. So if the S&P 500 can beat the broader market, why bother to invest anywhere else? A cognitive bias called herding only magnifies this effect: Every mention of the S&P 500 in conversations with friends and colleagues, as well as in the media, makes clients that much more eager to jump on the bandwagon.
Is Diversification as a Risk Management Strategy Dead?
The chart below gives advisors an easy way to talk to clients about the importance of keeping equity investments diversified. The main message is that it’s impossible to consistently pick the market’s best performing sectors year after year. Choose any color on the chart and you can see that today’s winning sector can easily become next year’s loser. Given that markets remain uncertain, diversification is still one of the best options for managing risk.
A Review of Asset Class Performance Over the Last 24+ Years
37.6%
28.5%
21.5%
20.3%
19.2%
18.5%
17.5%
12.2%
11.4%
0.2%
-5.2%
37.1%
23.0%
21.1%
16.5%
12.1%
11.4%
6.9%
6.0%
4.4%
3.6%
2.2%
33.4%
22.4%
19.7%
13.4%
13.4%
12.8%
9.7%
9.2%
2.3%
-11.6%
-18.7%
28.6%
18.8%
8.7%
8.6%
6.5%
5.0%
2.6%
1.9%
-2.6%
-17.0%
-25.3%
66.4%
32.7%
31.3%
27.9%
21.3%
21.0%
15.3%
2.4%
-0.8%
-2.1%
-2.6%
31.0%
11.7%
11.6%
5.0%
-0.3%
-3.0%
-5.9%
-9.1%
-13.4%
-18.1%
-30.6%
12.4%
8.4%
5.3%
5.1%
4.6%
2.5%
-1.2%
-2.6%
-11.9%
-14.6%
-21.4%
10.3%
9.6%
3.6%
-1.4%
-1.5%
-5.1%
-5.7%
-6.2%
-15.8%
-20.5%
-22.1%
57.6%
55.8%
47.3%
39.4%
36.2%
29.0%
28.7%
25.8%
19.6%
5.3%
4.1%
33.2%
29.3%
25.6%
20.4%
18.3%
13.0%
11.1%
10.9%
9.0%
4.5%
4.3%
34.0%
22.6%
14.5%
13.8%
9.3%
7.9%
4.9%
4.6%
3.5%
2.7%
2.4%
36.0%
32.1%
26.9%
25.7%
18.4%
15.8%
15.1%
12.9%
11.9%
4.8%
4.3%
39.4%
12.4%
10.8%
10.0%
7.0%
6.7%
5.5%
3.4%
1.9%
-1.6%
-17.6%
5.2%
-2.5%
-19.0%
-23.1%
-26.2%
-33.8%
-37.0%
-39.2%
-43.6%
-50.2%
-53.3%
78.5%
62.9%
58.2%
33.7%
28.5%
27.2%
26.5%
26.2%
20.0%
12.9%
5.9%
28.1%
26.9%
25.2%
18.9%
15.1%
15.1%
13.6%
10.3%
9.0%
6.5%
2.4%
10.7%
9.4%
7.8%
5.0%
2.1%
0.3%
-4.2%
-5.3%
-12.2%
-18.4%
-18.5%
18.5%
18.2%
17.1%
16.4%
16.4%
16.0%
15.8%
11.9%
6.8%
6.4%
4.2%
38.8%
32.4%
21.0%
19.7%
13.5%
9.1%
7.4%
1.2%
-2.0%
-2.6%
-2.6%
32.0%
13.7%
9.1%
6.6%
6.0%
4.9%
3.0%
2.5%
-2.2%
-4.0%
-4.3%
4.5%
3.3%
2.6%
1.4%
0.6%
-0.8%
-1.1%
-3.0%
-4.4%
-4.5%
-14.9%
21.3%
17.1%
12.0%
11.2%
7.8%
6.7%
5.4%
3.9%
2.8%
2.7%
0.3%
37.3%
31.7%
24.2%
21.8%
14.7%
14.0%
8.7%
7.5%
5.5%
3.8%
3.5%
1.3%
0.0%
-2.1%
-4.2%
-4.4%
-4.5%
-5.5%
-11.0%
-14.1%
-14.6%
-18.2%
31.5%
25.5%
23.1%
22.5%
22.4%
18.5%
18.4%
14.3%
10.4%
8.7%
7.5%
6.1%
2.1%
-3.1%
-3.5%
-3.7%
-3.8%
-9.8%
-11.5%
-12.8%
-13.0%
-22.0%
Source: Barclays, Bloomberg, Dow Jones, FactSet, MSCI Russell, Standard & Poor’s as of June 30, 2020. The indices are unmanaged, are not available for investment, and do not incur expenses. Click here for index definitions. The diversified portfolio is rebalanced to the original allocation annually. The performance shown is not indicative of the performance of any mutual fund or other investment product. Past performance is no guarantee of future results.
In the chart, the dark green squares show the performance of U.S. large caps, represented by the S&P 500 Index. We have added a diversified portfolio** (the black squares) to show how spreading risk across a range of investment categories provides a smoother ride through market cycles. The message for clients is that diversification offers a trade-off: In exchange for giving up the chance of being the market’s top performer, you can avoid being its worst performer. That’s the right trade-off for most clients since investors who stay diversified are more likely to stay invested during volatile times, are less likely to miss the market’s best days, and therefore have a greater chance of achieving their long-term personal financial goals. Remember, the best portfolios aren’t necessarily those with the highest returns, but rather those that clients can stick with in both bull and bear markets.
Managing Client Expectations
Taking time to educate clients about the importance of diversification will help keep their expectations for future performance rational. By focusing on the middle third of the chart—the range of the diversified portfolio’s performance—clients should be able to gain a sense for the trade-off between risk and reward. This point is well demonstrated in the bear-market years of 2000–2002 and 2007–2008. In each of these cases, the diversified portfolio outperformed U.S. large caps. In the absence of a crystal ball, diversification remains an essential strategy for keeping client portfolios on track.
For more ideas for coaching clients through volatile times, visit our resource center below.
*Diversification does not guarantee a profit or protect against a loss in declining markets.
**Diversified Portfolio Allocation: Investment Grade Bonds (IG Bonds): 30%, Municipals (Munis): 5%, U.S. High Yield Bonds (US HYB): 5%, U.S. Large Cap Equity: (US LC): 20%, U.S. Small Cap Equity (US SC): 10%, Foreign Developed Equity (For Dev): 10%, International Small Cap (Intl SC): 5%, Emerging Markets (EM): 5%, U.S. Real Estate (REITs): 5%, and Alternatives (Alts): 5%.
