3. What Causes Outperformance?
Professional investing involves the ability to fully understand the economies of the world and their financial instruments, then applying that knowledge to invest assets appropriately. By making investment decisions without a full understanding, additional risks may be added.
The biggest misconception that we find regarding diversification is the impact that currency movements have had on international investments. If an investor is deciding to drop international investments in favor of U.S. investments to chase returns, they should pay attention to what is causing the return differential.
The U.S. dollar has gained approximately 14 percent versus the yen, 14.5 percent versus the euro, 17 percent versus the Canadian dollar and 38 percent versus the Brazilian real over the last year as of the end of August. That means a large percentage of the return differential between U.S. stocks and a basket of diversifying international assets is based on currency movements. Therefore, is a bet on U.S. stocks over diversifier asset classes a bet on the U.S. stock market, or a speculative currency play?
4. You Can’t Have Your Cake & Eat It Too
Investors often look at individual positions in a well-diversified portfolio and express an interest in selling the positions that are down. Or, they may think that it was a mistake to allocate even a small portion to an asset class that is temporarily out of favor.
This mindset misses one of the key principles of diversification. With a diversified portfolio, the point is for some positions to be up when others are down. Any well-diversified portfolio should include positions that go down (or trail) when other positions go up, and vice versa.
If there is no dispersion in results of underlying portfolio positions, the portfolio is likely not a truly diversified portfolio, and that should raise questions. As long-term data has shown, there will be periods where the S&P 500 underperforms other asset classes.