Everyone wants to have the highest investment returns with the lowest amount of risk. But the average investor knows that this isn’t possible. So, the compromise is to have a diversified portfolio. A portfolio designed to produce an estimated rate of return to meet your goals, while managing risk to a level which makes an individual investor comfortable. Even though investors know they cannot predict the future, striving to create the ultimate portfolio is a driving force in the industry.
For this month’s ‘For Your Consideration’, I want to revisit the concept and purpose of diversification, and the underlying truth that not every investment can be a winner.
For many years the Yale Endowment Fund investment team has (for an undefinable reason) been known by many as the premier investment strategist. The fund, a mix of stocks, bonds and alternative investments, has seen returns envied by any investor who’s paying attention. Many ‘advisors’ have tried to create a similar strategy as the Yale Endowment Fund, hoping to mirror its success.
However, over the last decade, opinions of the Endowment have soured. Articles have been written about how the returns have lingered behind indexed strategies consisting of large cap companies (otherwise known as the S&P 500). A recent Wall Street Journal article discussed the Endowment’s poor year to date returns (6.5%) and how it has been inferior to the S&P 500.
The concern I have with judging returns over the past decade, is not how former darlings like the Yale Endowment, and other diversified strategies, are lagging the S&P 500. Rather, my concern is that the S&P 500 has done so well over a long period of time it has created a major recency bias among investors who are very aware of this index and the companies it tracks.
I fear that the general public has begun to cling to a theory that a single asset class or index is the winning investment strategy, both now and forever more. The problem is that history has proven that things will change, and the markets will always find a way to disappoint the greatest number of people. When the current ‘winners’ are the better-known assets and companies, receiving more media attention, the average investor will make the mistake of moving away from diversification and develop a concentrated position into these currently high-priced assets.
There are two general purposes of diversification. First, the cliché “don't put all your eggs in one basket”. Make sure that your funds are spread over a series of assets, so that one bad asset can’t devastate your portfolio. By diversifying you will have some exposure to the next big winner without knowing beforehand. Likely, the next big winner will be an asset or asset class that the general public knows very little about, and as a result are paying very little attention to today.
As the average investor reacts with some disgust as some investments in their portfolio are ‘under-performing’, they may mistakenly bail on those assets and move funds away from the next year’s potential winner. This is a bad decision, because the truth is that diversification’s primary objective isn’t to have the best returns. If your portfolio is properly diversified, you will have no choice but to have under-performers as part of your portfolio. It is impossible for every holding in a diversified portfolio to have the highest returns among all assets during any given period.
The second purpose of diversification is to help control volatility and to help prevent emotions from causing bad judgement. As much as it is impossible for your diversified portfolio to avoid under-performers it should likewise be impossible to avoid over-performers (especially if you have a long enough time horizon). When the financial world becomes tumultuous, and it is hard to find the assets that are maintaining even a small positive return, a properly diversified portfolio should have already found them.
A diversified portfolio will prevent total exposure to an asset or asset class having ‘the worst year ever’, at the detriment of being totally exposed to those having ‘the best year ever’. Because of this reality, it is almost a certainty that a diversified portfolio will always under-perform the current ‘winners’.
Unfortunately, for the past several years, some of the best performing indexes and stocks have also been some of the most well-known. I worry, as people flock to what they know, there will be many people with a strategy that does not include protection from the times when the strategy inevitably stops working.
The Yale Endowment does not need to be compared to the S&P 500 or any other index. The common investor or advisor should not compare their returns to the Yale Endowment or any other index. If diversification is helping you get closer to your goals, while lowering volatility and your stress level, it is working. There is no benchmark needed for comparison.
Under-performing assets in a diversified portfolio is not a reason to doubt your strategy. Even during periods when the ‘winners’ are very well known. There will be a day, in fact there will be several days, months and years, when the best performing assets will be investments you have very little knowledge, but are glad you own.
Diversification is your friend. Your rate of return hampering, yet very reliable, always there for you friend.