Diversification is a key principle of portfolio management. It is the practice of not putting all of your portfolio’s eggs in one basket. And its importance can often be forgotten due to specific biases we all can fall victim to.
The paradox of diversification is that we’re most likely to need it just when we feel we don’t. If one sector or area of the market is doing well, why would you want to allocate elsewhere?
Indeed, diversification often means not chasing performance, having less exposure to current “winners,”’ and giving up returns now in exchange for the promise of protection later. It’s the practice of delayed gratification for your investments.
Equity markets, particularly domestic equities, have outperformed other asset classes by a wide margin since the March 2009 market bottom during the financial crisis.
Even accounting for the market drawdown in February-March 2020, domestic equity ETFs like the SPDR S&P 500 ETF Trust (SPY) and the Invesco QQQ Trust (QQQ) have seen double-digit annualized returns over the trailing 10 years.
International equity ETFs such as the iShares MSCI EAFE ETF (EFA) or the Vanguard FTSE Emerging Markets ETF (VWO) have not risen nearly as much, with annualized returns in the midsingle digits over the trailing 10 years.
And broad-based bond ETFs such as the iShares Core U.S. Aggregate Bond ETF (AGG) have gained 2.3% annualized over the past 10 years. While this makes sense given the return profile of equities versus fixed income, it has also made allocating to fixed income more painful over time as investors see equities experiencing outsized gains with seemingly no end in sight.
The relatively smooth ride that equities have taken since 2009 has tricked some investors into allocating beyond their risk tolerance. In fact, risk often feels good when markets go up.
QQQ, which has large exposure to high growth mega cap tech stocks, has dramatically outperformed broader domestic equity funds like SPY.
But the year so far is a reminder that the true measure of risk tolerance is how investors feel when markets stumble. Though it is a short time period, year-to-date performance of these ETFs reminds us that risk matters the most when markets are falling.
While fixed income markets face their own set of problems, including high potential for rising rates, AGG has only fallen by 4.7% so far this year relative to double-digit drops for the mentioned equity ETFs.
Investors who haven’t rebalanced back to targets or who have otherwise taken more equity exposure than they should to capitalize on a stock market that has mostly gone in one direction over the past decade-plus are feeling the pain of not adhering to their asset allocation.
Given the length and extent of outperformance of equity markets over fixed income, it might take a prolonged drawdown period for a more diversified portfolio to outperform one with more equity exposure.
But without a crystal ball, investors can’t predict the future, and should position their portfolios in such a way that their investment goals are still in reach even if the market drawdown lasts for a substantial amount of time.
Forgotten Asset Class
Beyond fixed income, investors have also been less likely to allocate to low-correlation asset classes such as commodities.
Commodities offer a return stream that has relatively low correlation to both equities and fixed income, offering diversification benefits for a portfolio. But in contrast to equities’ ascension over the past decade, most commodity funds have declined until recently.
While investors have tactically added to these positions, with over $12 billion in net inflows into commodity ETFs year-to-date, they likely missed at least some of the benefit that would’ve been experienced had a target allocation to this sleeve been held.
How To Combat
So what’s an investor to do? Those who work with a financial advisor often have an advantage here, as there’s an objective intermediary to help set up an appropriate asset allocation and stick to the plan, even in difficult market environments.
But advisors aren’t perfect, and can be guilty of this complacency too, especially those who are younger and newer to the field and have never advised through a prolonged drawdown. Clients of advisors aswell as DIY investors should consider whether their portfolio is positioned for the market of the past or for the potential market of the future, regardless of what happens.
Nothing lasts forever. The market will keep moving through its cycle, with various asset classes seeing periods of outperformance and often surprising us with what happens.
The best we can do is diversify, allocate in proportion with our tolerance and ability for risk, and hold on for the ride.