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Diversification Does Not Always Pay.

Meridian Points

Diversification

 

The S&P 500’s return of 13.55% marks the 6th consecutive year of positive stock market performance since we emerged from the Great Recession. This has only happened one other time in history, from 1898 to 1903.

Over the past few weeks I have noticed some head scratching as investors compare their 2014 account returns to that of the S&P 500. Why, they wonder, weren’t their accounts up as much as “the market” last year?

Diversification is the culprit. Very few people with all-stock portfolios achieved S&P 500 type performance because only a portion of their stocks were invested in the S&P 500. The “problem,” if one exists, is that the current bull market is very narrow – it’s concentrated in domestic, blue chip companies. It has long been an industry adage that an investor with a properly diversified portfolio is typically unhappy with 1/3 of his portfolio at a given time. Right now that proportion may be even higher.

What is diversification? 

Diversification is one of the key elements of portfolio construction. In plain terms, it’s how we avoid putting all of our investment eggs in one basket. Instead, the strategy combines a variety of assets in order to lower the overall risk of an investment portfolio.

You might use a mix of mutual funds, individual stocks and bonds, and exchange-traded funds to build a diversified portfolio. Further diversification can be achieved within your stock portfolio by including not only large company, blue chip stocks but also stocks of small and medium size companies. You might incorporate bonds with varying maturities and credit qualities. Diversification could also mean investing in foreign stocks and bonds, because they tend to be less closely correlated with their domestic counterparts.

Your allocation to each of these broad categories should be based on your investment goals, comfort level with market fluctuations, and time frame for needing the use of the money. In other words, your own asset allocation should be an outgrowth of your personal financial plan.

How do you benefit from diversification?

The idea behind diversification is that the whole is greater than the sum of its parts; a portfolio of different kinds of investments will, on average, yield higher returns while posing a lower risk than any single investment within the portfolio.

Diversification strives to smooth out both risk and volatility of returns in a portfolio, such that the positive performance of some positions will offset the negative performance of others. Diversification is possible because the building blocks of the portfolio are imperfectly correlated with one another. They are specifically selected not to be.

Why did diversification disappoint us last year?

As it turns out, when you spread around risk, you also spread around opportunity. And in 2014, opportunity was concentrated – namely in the companies that comprise the S&P 500. In the rock/paper/scissors game of market returns, the U.S. economy trounced foreign economies, stocks of large company (“blue chip”) stocks trounced those of small companies, and passive management (i.e. indexing) trounced actively managed funds.

As a result, equity investments that don’t track the market – and were chosen for exactly that reason – were pretty disappointing last year.

View diversification in a more flattering light.

Our constant access to news and market information has bred a very short-term oriented investment culture that can distort our view of some constants when it comes to long-term investing. It’s not that different from looking at a Monet painting; when you stand right in front of it you think that you see one thing, but the further you step back from the canvas, the clearer the picture becomes.

Similarly, panning out when it comes to your investment perspective provides clarity when it comes to some fundamental truths of investing:

  • Market performance is not predictable – it’s not possible to “time” the market;
  • Active mutual fund managers typically either significantly outperform or significantly underperform passive or index funds; and
  • Your own comfort level with stocks and volatility of returns is often fluid and can be influenced by market extremes.

Investors are always best served when they focus on investment philosophy and process rather than react to short-term results and headlines. Reacting to events in the short-term may provide relief, but it can hobble you in the long run. Like many of the most important things in life, investing is a marathon, not a sprint.

Meet the Author

 

Tom Coulter, CPA

President

Tom is the President and a founder of Meridian Trust. Tom graduated from The University of Tennessee, Knoxville, in accounting with honors, in 1978. Tom previously worked for the international accounting firm, Deloitte. He later joined the financial medical advising firm, FIS Associates, before founding Meridian Trust in 1997. Tom has worked extensively in retirement planning, taxation, estate and financial planning and investment management. He is a Certified Public Accountant, a member of the American Institute of CPAs (AICPA), and the Tennessee Society of CPAs (TSCPA). Tom is also credentialed as a Personal Financial Specialist (PFS) by the AICPA.