How Diversification Became A Four-Letter Word
For the fifth consecutive year, responsible financial advisors all across the country are apologizing to their clients.
Why?
Because the diversified portfolios they have built are lagging the S&P 500 … for the fifth consecutive year.
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Any way you slice it (from conservative to aggressive), diversification has failed to keep pace with the S&P 500, which has generated an annualized return over the past five years of 15%.
“Why aren’t we holding more S&Ps,” they ask. “That is what’s working. Even a monkey could see that.”
Indeed, and monkeys can be pretty good investors at times, simply by throwing darts. But I digress.
The ratio of U.S. stocks to the rest of the world is at a record high. While the S&P 500 has doubled since the start of 2012, the MSCI World excluding the U.S. (ACWX) is up only 25%.0.
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Compared to bonds, the gap is even wider, as the largest U.S. bond ETF (AGG) has generated a paltry 2% per year since 2012 versus 15% for the S&P 500. Here too the ratio is currently at all-time highs.
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And that’s how diversification became a four-letter word.
International bonds, U.S. investment grade bonds, U.S. Treasuries, Asia-Pacific stocks, European stocks, and Emerging Market stocks have all badly lagged U.S. equities over the past five years.
In the iShares asset allocation ETFs suite, U.S. equities make up just 42% of the portfolio in the most aggressive portfolio (AOA) and only 17% in the most conservative (AOK). It is mathematically impossible to keep pace with strong run in U.S. stocks when you own anything other than U.S. stocks.
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Does that mean investors should abandon diversification and go all-in on the S&P 500 today?
- Only if they are 100% sure that the next five years will look exactly like the past five (historically, the S&P 500 has outperformed the MSCI World ex-US Index in 54% of calendar years, little better than a coin flip).
- Only if they can handle significantly higher volatility (since 2012, the S&P 500 has an annualized volatility of 13% vs. 6% for the AOM moderate allocation ETF).
- Only if they can handle much higher drawdowns (the S&P 500 lost 37% in 2008 vs. 10% loss for a 40/60 allocation to US stocks/bonds).
Of course, no one can be sure of what will happen over the next five years and few can handle higher volatility/drawdowns than their risk tolerance suggests.
Which is why we diversify in the first place: to protect ourselves from the unknowable future and the visceral responses we all have to volatility/drawdowns. That is nothing to apologize for, even if it means badly lagging the S&P 500 over a five-year period. It is actually something to be lauded, because it would be far easier to give in to your clients demands today and take a punt on the S&P 500 than to defend diversification. But defend it you must if you wish to remain a professional in this business, for a large part of what you are being paid for as an advisor is protecting your clients from themselves.
Anyone can go out and buy the S&P 500; few can stick with it through the ups and downs. The S&P 500 is not your benchmark as an advisor; your benchmark is helping your clients meet their goals by taking the highest probability path. That path necessarily includes diversification and necessarily excludes betting the ranch on any one stock or asset class.
Your clients may not remember the last time when the S&P 500 had a down year or care to learn about historical drawdowns, but it is your job to remind them. There is no such thing as risk-free reward. Diversification is not dead.
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Disclaimer: At Pension Partners, we use Bonds as our defensive position in our absolute return strategies for all of the above reasons. Bonds have provided a more ...
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