Diversification Means Some Leaders and Some Laggards

eggs in one basketCommon sense tell us: “Don’t put all of your eggs in one basket.” Investment professionals give it a fancier name: “Modern Portfolio Theory (MPT)”, first articulated in 1952 by Nobel Prize winner Harry Markowitz.

The concept is that, regardless of what all the financial pundits and media people say and write, we can’t predict the future. So, we spread our bets across a variety of investments. The trick, mathematically, is to consider how the price of each investment varies in relation to the others. We use the term correlation and recognize that there is a benefit to non-correlation. That is, when some are zigging, others are zagging. The objective with diversification is that for the same level of risk, we can earn higher returns and/or lower volatility.

Here’s the catch: a truly diversified portfolio will almost always have a portion of the portfolio that is underperforming. Behaviorally, all of us hate to lose. Worse yet, we often fixate on the negative, drum up feelings of regret and develop “if only” thoughts.

Let’s take a look at some leaders and laggards over the last 20 years:

Investment returns-2014_Page_1

There’s a lot of data in this chart. Click on it for a full size image. Each color represents a different asset style. Last year, the S&P 500 growth (maroon) was the top dog. MSCI EAFE (grey) was at the bottom of the list. Yet, follow the colors from year to year. Leaders one year often don’t repeat the next year. In fact, sometimes, like “chutes and ladders,” they go from top to bottom. If you have a diversified portfolio, you can be assured you’ll have some leaders and some laggards.

The key is how the elements of your portfolio work together. Let’s look at the first two months of 2015 as an example:

In January, the S&P 500 came back to earth. In fact, it was down 3%, as were small caps. International and emerging market stocks were down about 1%. So, a diversified equity portfolio in January was likely down 2%. On the other hand, a diversified fixed income portfolio was up perhaps 1-2%, and a diversified liquid alternative portfolio was up almost 2%. So, even though domestic stocks were down 3% in January, a diversified portfolio could have been close to break-even.

In February, things changed. Stocks got hot again. The S&P 500 and small caps were up almost 6%. International and emerging markets were up about 5%. Fixed income and alternatives were just about unchanged. So, a diversified portfolio might have been up 2-4% in February.

In each month there were leaders and laggards zigging and zagging. And the big leaders one month were not the same the next month. The key is the non-correlation benefits between the various holdings that can produce higher returns and/or reduce volatility.

We need to focus on the whole portfolio, not the laggards. We have to fight the bias of “fallacy of composition” which causes us to reflexively assign the attributes of one piece to the whole. In investment terms, that’s noticing one asset style doing poorly and concluding, incorrectly, that the portfolio overall is flawed.

Finally, we all suffer in some measure from the phenomenon of “if only.” The “science of regret” is quite complex. A key point is to setting appropriate benchmarks. For example, our clients know that their Investment Policy Statement (IPS) gives us our “marching orders” for managing their portfolio and includes a targeted long-term net rate of return for their portfolio. That’s the appropriate benchmark. Comparing performance results for all your investments to the top performer in the year is not only an inappropriate benchmark, but can be damaging if the result is rebalancing your allocations to chase recent performance.

Focus on diversification- use of all three asset classes: equities, fixed income, and liquid alternatives, and appropriate diversification of asset style within each asset class. You’ll have leaders and laggards. The real key is avoid our behavioral instincts to focus on the laggards and, instead, to celebrate your overall long-term performance and the fact that diversification is working for you.