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.

1. Treat Your Portfolio Like Your Body

The best example to equate to investing is personal health. Things that people do to affect their personal health throughout their life have a lasting effect on their ultimate health and quality of life.

Eating cheeseburgers every day for 20 years has an impact similar to not contributing to a 401(k). Selling out over fear at a market bottom is like shattering a leg sky-diving. These are things that can’t be fully recovered from.

Just like failure to take good care of their bodies, investors tend to abandon sound investment strategies for unsound ones and make poor investment decisions. For example, let’s do an exercise with Investment A and Investment B.

Following are the two assumed annual rates of return patterns over three years:

Investment A or Investment B?

Investment A: 5 percent, 5 percent, 5 percent

Investment B: 8 percent, 8 percent, 8 percent

Which one would the typical investor choose? Most investors would choose investment B. Any rational person, given only this information, would choose the higher rate of return.

What about over five years?

Investment A: 5 percent, 5 percent, 5 percent, 5 percent, 5 percent

Investment B: 8 percent, 8 percent, 8 percent, -10 percent, 8 percent

Adding years four and five helps to give more information.

If an investor would stay invested in option A, the total return would be about 28 percent. Option B would provide about 22 percent. If an investor switched from option A to option B after year three and stuck with option B for years four and five, the result would be about 13 percent after year five. Worse yet would be the investor who switched back to option A in year five, after trailing with option A in years one through three and losing money in option B for year four, which would yield about 9 percent.

Many investors are facing a similar decision now. Diversified portfolios have largely underperformed the S&P 500 the last few years. Simple logic would pull investors toward investing solely in the S&P 500. However, that logic leads to the worst result in the example above.

A year of gains, or even five years, can be wiped out in a matter of days. As such, many investors have been irreparably harmed by abandoning solid strategies to chase recent winners.

2. Don’t Gamble With The Future

The Ohio State football team kicked off this season ranked No. 1 in the Associated Press preseason poll for the eighth time. However, it has failed to finish No. 1 in the previous seven times it has held the preseason top ranking. Investing is not about simply betting on the favorite. For that matter, prudent investing is not about betting at all.

The stock market is fundamentally different than gambling, primarily because the odds are in the investor’s favor in investing. Gambling typically involves a toxic cocktail, often combining games that are stacked against the player with frequent opportunities for personal decisions.

Mathematically, players are not supposed to win in gambling over time. Likewise, casinos know that individuals are likely to intervene and reduce their odds of success, instead of the other way around.

The casino takes virtually no risk in the games themselves over time. In almost all cases, in the long run, the house will always win. The games, the odds and the payoffs are all carefully designed to ensure this outcome.

House Advantages:

Baccarat: 1.17 percent on bank bets, 1.36 percent on player bets

Blackjack: 0.5 to 5.9 percent for most games

Craps: 1.4 to almost 17 percent, depending on the bet

Keno: 20 to 35 percent

Roulette (with double zeros): 5.26 to 7.89 percent, depending on the bet

Slots: 2 to 25 percent (average 4-14 percent)

Video Poker: 0.2 to 12 percent (average 4 to 8 percent)

Wheel of Fortune: 11 to 24 percent

(Source: USA Today, Vegas gambling guide: Understanding the odds - Bob Sehlinger, Unofficial Guide to Las Vegas | Published on April 8, 2014)

As long as the house has a marginal advantage, it will win over time with volume. A larger advantage simply decreases the time necessary to ensure its profit. The more each player plays, the closer the odds will get to those listed above. Obviously, some players will marginally beat the odds; however, that is a risky bet.

On the other hand, according to research by J.P. Morgan, the long-term odds of success in investing are in the investor’s favor. Looking at periods from 1950 to 2014, there were zero five- or even 10-year rolling periods where a balanced portfolio of indexes lost money. This only makes sense. The world economy grows over time, interest and dividends are created, and inflation should be expected.

In investing, the odds are in the investor’s favor if they stay disciplined in a quality global allocation over time and are typically reduced by investor intervention. Investors often sell losers and buy winners. Disciplined rebalancing adds value by doing exactly the opposite.

Investors win by staying disciplined and understanding that the stock market isn't supposed to go up every day and compound at rates that exceed global growth and dividends, which would be mathematically unsustainable over time. That would be akin to eating 8,000 calories a day and burning 3,000 and expecting not to gain weight.

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.

5. Your Gut Is Mostly Wrong

Investing can be counterintuitive. Investors tend to try and use information they have received in other areas of their life and apply those principles to investing. Oftentimes, sayings such as “my Daddy always said” or “I heard about this at the gym” or “I have a feeling that” can lead to actual financial decisions.

One main principle that is counterintuitive is the ongoing nature of the stock markets. While we arbitrarily assign measurement periods, such as month-to-date or year-to-date or five-years trailing, the stock market doesn’t really care what the calendar says. Fortunes can be made or wiped out in unfair time periods, and January results don’t care that you were a top performer at the end of December.

For example, let’s apply this principle to education. A college degree is an accomplishment. I remember looking at my first diploma and saying, “No one can ever take this away from me.” I worked hard and accomplished it.

What if your alma mater set up a system where they could send you random texts anytime between 9:30 a.m. and 4 p.m. on a weekday, and if you didn’t respond within 15 seconds with the correct answer, you had to surrender your degree?

What if the classes never really ended, and your grades in Sociology 101 were adjusted all day by how you interacted with others, and if your lifelong grade dropped low enough that you had to start the class over again?

Sounds crazy, right? That’s because investors are people, and people are used to a winner and a loser over a defined time period. At some point in nearly every sport, the buzzer goes off, and a winner and loser are declared.

What defines a winner in investing? We all know that most actively managed mutual funds fail to outperform their benchmark over time (see S&P Index Versus Active Reports). Likewise, we know through research that most star managers eventually regress to the mean. Does that mean there are no winners?

We believe the winners are the investors who properly diversify and receive appropriate risk-adjusted returns over time.

What Should Investors Do?

Serious investors should invest primarily in a disciplined, globally diversified portfolio over time.

Like guidance to eat a balanced diet, we recognize it is difficult to stick to a plan. The dessert menu (speculation), candy bar aisle (market timing) and fast-food line (lure of potential outperformance) will continue to be distractions.

However, a globally diversified portfolio over time provides investors with the highest likelihood of appropriate risk-adjusted returns, not to mention that many diversifiers are currently trading at historically attractive prices.

ValMark Advisers Inc. is the manager of the TOPS Portfolios of ETFs. ValMark started managing "TOPS" separately managed accounts of ETFs in 2002. The firm manages more than $5.1 billion in ETFs for retail and institutional clients in multiple investment products. Email:[email protected]; phone: 800-765-5201. For a complete list of relevant disclosures, please click here.

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