New Year's Resolution: Stay Committed to Diversification
Pick any network, scholar, professional or textbook. When they talk about the most common and fundamental approach to investing, they preach “diversification.” The concept is pretty simple. “Don’t put all your eggs in one basket.” The idea is that by spreading out the types and asset classes of investments you own, your risk and volatility may be lower over the long term. That’s because it is likely that you’ll be on both sides of that coin for any given time period. As much as one investment may go up, another may go down. You don’t have to guess which one will be best at any given time.
I’m a believer in diversification, especially for long-term investors who need to participate in growth greater than what a bank may be paying in interest, but also cannot incur steep drawdowns based on their phase of life. I’m a believer because for some time periods, diversification will lessen losses when compared to a portfolio concentrated in any one market or asset class.
But we also need to recognize that for other time periods, your diversified holdings will underperform a portfolio concentrated in one market or asset class. Rarely does any one category dominate for an extended period as we’ve seen with large U.S. companies since 2009.
This can be the downside to diversification, and frankly, is when most investors feel “left behind” when they hear or read about better returns found elsewhere. Many diversified investors have felt this since the U.S. recovery began in mid-2009. In general, large U.S. companies and fixed-income markets did well. But diversified investors whose portfolios contained exposure to categories such as international or emerging markets equities or commodities such as oil or gold have felt punished compared to the markets here in the U.S.
This is a time common for investors to review and assess their holdings. So when reviewing holdings, and the diversification of those holdings, the big question that investors need to ask is whether this is the time to throw in the towel on diversification or be patient and wait for the tide to change. I’d ask that you truly consider this before making any rash decisions.
No one can say with any certainty what lies ahead. Perhaps reviewing economic cycles will help. For example, the U.S. has been in a steady state of recovery and easing monetary policy for nearly six years. While many may say that expansion in the U.S. is not over, despite more Fed interest rate hikes throughout next year, other markets and economies may be entering a period similar to when the U.S. started its economic stimulus.
In the U.S., monetary policy is one of the key drivers to the outperformance of U.S. equity markets. Is it reasonable to conclude that other economies and markets will grow? The answer, of course, is…maybe.
It’s part of my job to assess these and other factors when giving advice. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Nor does diversification protect against market risk. But, I still believe in diversification. Investors should think twice before they remove some of the underperformers of the past few years from their portfolios.