Lesson 3: Diversification Is Always Working; Sometimes You Like The Results And Sometimes You Don’t
Everyone is familiar with the benefits of diversification. It’s been called the only free lunch in investing because, done properly, diversification reduces risk without reducing expected returns.
However, once you diversify beyond a popular index, such as the S&P 500, you must accept that you will almost certainly be faced with periods, maybe even long ones, when a popular benchmark index outperforms your portfolio.
Popular benchmark indexes are covered by the financial media on a daily basis. The noise created by the media will test your ability to adhere to your strategy.
Of course, no one ever complains when their diversified portfolio experiences positive tracking error, meaning it outperforms the popular benchmark. The only time you hear complaints is when the diversified portfolio underperforms, and results in negative tracking error.
As Figure 2 indicates, 2014 was just such a year. To demonstrate returns of various equity asset classes, I used the asset class funds of Dimensional Fund Advisors (DFA). (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.)
Figure 2: DFA 2014 Fund Returns
|Fund||2014 Return (%)|
|Large Value (DFLVX)||10.5|
|Small Value (DFSVX)||3.5|
|Real Estate (DFREX)||31.1|
|Fund||2014 Return (%)|
|Large Value (DFIVX)||-6.9|
|Small Value (DISVX)||-5|
|Real Estate (DFITX)||11.1|
|Emerging Markets (DFEMX)||-1.7|
|Emerging Markets Small (DEMSX)||3|
|Emerging Markets Value (DFEVX)||-4.4|
In some ways, 2014 was similar to 1998. During both years, U.S. stocks outperformed international stocks, and large and growth stocks outperformed small and value stocks. What’s important to understand, however, is that we should want to see a wide dispersion of returns. If we didn’t, then when one asset class performed poorly, we could expect them all to perform poorly, and to similar degrees.
A wide dispersion of returns also provides investors with opportunities to rebalance their portfolios, buying underperformers at relatively lower prices (and at a time when their expected returns are now higher) and selling outperformers at relatively higher prices (and at a time when their expected returns are now lower). Of course, that requires discipline, which is a skill many investors don’t possess.
Figure 3 presents evidence from 1998 and 2001 indicating the importance of both diversification and discipline.
Figure 3: Returns For Key Market Indexes, 1998 & 2001
|Year Return (%)||S&P 500 Index||Russell 2000
(U.S. Small Stocks)
|Russell 2000 Value
(U.S. Small Value Stocks)
We’ll cover lessons four through six—which include some instructive information on the accuracy of economic and financial forecasts—in our next post.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.