5 Thoughts On Diversification

September 22, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is written by Michael McClary, chief investment officer of Akron, Ohio-based ValMark Advisers, which markets the “TOPS” brand of asset allocation models.

Many advisors would agree that the benefits of asset allocation and global diversification are currently not an easy principle for many investors to appreciate. In nearly every financial advisor’s office across the country, investors are questioning why they shouldn’t be invested fully in a product that mirrors the S&P 500, given recent outperformance.

It is not hard to understand why some investors may want to put 100 percent of their money into U.S. stocks. Why not? The home team is winning.

The domestic economy seems on the surface to be one of the world’s strongest. Likewise, fellow investors and the Fed have stepped in to fuel the current bull market each time it seems to sputter. Beyond that, it is patriotic.

Recent Event Focus
We are all prone to focusing on recent events. After a particularly cold winter, we would typically begin to doubt global warming. After the electricity goes out for a few hours, we start thinking about purchasing a generator. Likewise, after U.S. stocks have outperformed other diversifier asset classes, we begin to question why we should diversify at all.

Investors across the country are blowing cigar smoke into their doctors’ faces, saying, “What health risks? I’ve been smoking for a year and I’m fine,” or worse yet, “Why didn’t you let me smoke? My neighbor has been smoking for a year and is fine.”

While a multitude of agencies have spent decades educating about the dangers of smoking, with proven results, the financial education system in America has been much less coordinated. Imagine if the cigarette companies could still advertise the health benefits of smoking. Seems absurd, even though there are investment strategies advertised each day that are toxic to investors’ portfolios, and many investors are investing with little-to-no direction at all.

We believe giving up on diversification is a big investment mistake.

5-Year Trailing Results

We see more and more investors with the desire to put all of their chips on Uncle Sam. It’s not hard to see why. The easiest thing to use for comparison of two investments is performance. Looking at markets over the last five years, anyone can see that the S&P 500 has outperformed EAFE by nearly 900 bps annualized over the last five years.

YTD -5.36 -3.97 -16.02 -6.5 0.78
1 Year -1.83 -11.37 -26.61 -9.3 2.33
3 Year 13.38 7.4 -3.61 8.38 1.65
5 Year 14.09 5.36 -2.32 7.95 3.18

Source: Bloomberg. Data as of 9/4/2015. Data over 1 year is annualized.

It is important to note that emerging markets outperformed the S&P 500 by 34 percent and 50 percent in 2007 and 2009, respectively. Likewise, investors may be forgetting that the S&P 500 dropped more than 50 percent from peak to trough during the 2008 financial crisis, or that the United States went through a credit downgrade in 2011.

In this piece, we will explore five things to consider before giving up on diversification. While reams of quantitative data exist to support diversification, we will focus mainly on qualitative aspects of investing in a diversified portfolio over time.

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