Diversification By Design

by Tim Utecht, CFA 

2013 Investment Performance

Seeing those numbers, it's easy to question the concept of diversification. Give me a full dose of U.S. stocks! It doesn't take a numbers geek to see that any combination of those assets resulted in a lower return than U.S. stocks alone last year. A mix of 50% bonds, 20% U.S. stocks, 20% international, and 5% each of real estate and commodities combined for a return of about 8% - before any investment costs. The diversification route might seems like a bad choice.

But in reality, that's exactly the way diversification is supposed to work. You won't have everything invested in the best category, but you won't have it all in the worst place either. Diversification gives us the opportunity to participate in the assets that perform well in the short run, while gaining the benefit of potential asset class returns in the long run.

If we look farther back, it turns out that 2013 was the exception rather than the rule for U.S. stocks. Last year was the first time in the past 15 calendar years that U.S. stocks topped the performance list for the categories shown. Commodities and real estate each took the prize in five calendar years, while international stocks won three times. Bonds even posted a victory. U.S. stocks were NOT the top investment in 14 of the past 15 years.

Perhaps your preference would be to select the best performing asset each year (before it happens). That would be wonderful, but it would require a plethora of prognostication. Here's an example of how difficult it can be.

Perhaps we would seek expert advice for our market forecasts, rather than rely on our own crystal ball. Someone like Jeremy Siegel from the University of Pennsylvania. Professor Siegel appears on television frequently, discussing his outlook for markets. He also has a website offering a market newsletter (via subscription) to point us in the right direction. (He's referred to as "The Wizard of Wharton" on the website, but we can overlook pomposity in exchange for rock solid advice, can we not?)

Here is what Dr. Siegel had to say in February of 2008:

"I believe that the stock market will do better in 2008 than it did in 2007, when it chalked up a 5.5% return, the fifth year in a row that the market went up. Year-ahead forecasts for the stock market are notoriously difficult, but I believe that a 10% to 12% gain is possible, on the heels of a recovering financial sector."

If you are so inclined, you can read the rest of Professor Siegel's 2008 forecast and commentary. In it, he states his belief that investors had "overreacted to the mortgage crisis" and the U.S. economy would "skirt a recession." I think we can charitably classify that forecast as somewhere between "dead wrong" and "just plain embarrassing."

While acknowledging the challenges in making forecasts, he nonetheless gave us one: a 10% to 12% gain for stocks in 2008, a year that finished with losses of 37%. His forecast missed the mark by nearly 50 percentage points. "Notoriously difficult" indeed. And that's just one market. Throw in the complexities of predicting returns for two dozen countries along with additional asset classes and you can see the futility of the forecasting game.

By the way, Dr. Siegel's forecast is for returns of 10% to 15% this year. How comforting.

Famed investor Warren Buffett, in contrast, wrote this in a 2008 New York Times editorial:

"I can't predict the short-term movements of the stock market. I haven't the faintest idea as to whether stocks will be higher or lower a month - or a year - from now."

I'll go with Warren on this one. We diversify precisely because we can't know exactly what the future has in store. We combine things that tend not to do the same thing at the same time. We know these assets have provided very good returns over time, but they are quite unpredictable in the short-run.

Diversification is not exciting - by design. It's a way to reduce the possible worst case outcomes. In the words of economist Burton Malkiel (professor emeritus at Princeton), "Diversity reduces adversity." Diversification doesn't eliminate risk, but it's a way to mitigate and manage it. The goal is a smoother ride to reduce the painful (and inevitable) bumps and bruises of investing.