Diversification - The Worst Way to Invest Except All Others
In the wealth management industry, there are several tongue-in-cheek sayings about diversification:
- If there isn’t something you hate in your portfolio, then you’re not diversified.
- Diversification means never owning enough of the best-performing asset in your portfolio and owning way too much of the worst.
- Diversification means always having to say you’re sorry.
- Diversification is the worst way to invest - except all the others!
As an advisor, it can be hard to keep investors focused on what works in the long term when it seems everything is working in the short term. Diversification often looks overly prudent, especially near the end of a giant bull market.
When interest rates are 0%, every asset has value. When the risk-free rate (10-Year Treasury) is 3.5%, pencils get sharpened.
But common sense (and history) dictate that markets driven by FOMO (Fear of Missing Out) eventually turn into FOGO (Fear of Getting Obliterated). It's during these periods that diversification really proves its worth.
We’re seeing that right now with various high-flying investments such as unprofitable tech and crypto.
Here are some examples of those high fliers and where diversification helps investors:
There’s an ETF that tracks the performance of meme stocks (MEME), which were the day trader darlings of the pandemic. Roundhill Investments, the creator of this ETF, defines these stocks as “equity securities of companies that exhibit a combination of elevated social media activity and high short interest…to capture trending stocks as they emerge.” Think GameStop, AMC, and Robinhood.
As you’ll see, this basket of stocks is down 63% since inception 12/8/21.
As recently as February 2021, ARK Innovation ETF (ARKK) was outperforming the S&P 500 by more than 500% since its inception. Cathie Wood, their star fund manager, became a media darling, making appearances on TV, radio, and on the cover of magazines.
Now in 2022, ARK has done a complete roundtrip and is underperforming the S&P 500 since inception.
How about Facebook? (I still can’t bring myself to call it META!)
This has been an extremely profitable tech company. But recently, Facebook’s CEO took the company in a new, uncertain, and expensive direction. Investors responded negatively.
In February of 2021, META had a near 600% historical outperformance relative to the S&P 500. Many investors and employees rode this concentrated stock position higher for years, only to lose 63% in 2022.
META is now underperforming the broad diversified index (S&P 500) since its initial public offering.
And then there’s the crypto universe, which isn’t just experiencing a “crypto winter” but a bona fide crypto ice age.
This year, there’s been one major implosion after another in the crypto space, including the collapse of Three Arrows Capital, Terra/Luna, Celsius Network, Voyager Digital, BlockFi, and now, FTX. (FTX’s founder was just arrested in the Bahamas on charges of wire fraud, security fraud, money laundering, and conspiracy to avoid campaign finance regulations – aka running a Ponzi scheme.)
Source: Helios Quantitative Research, Bloomberg, as of 12/9/2022
Slow and Steady Wins the Race
In 1990, Harry Markowitz won a Nobel Prize in Economics for his work on Modern Portfolio Theory – a mathematical framework for gauging risk, return, correlation, and diversification when assembling a portfolio. According to Markowitz, "Diversification is the only free lunch in finance."
Diversification helps to manage risk and improve returns. And it’s never been easier to achieve diversification given the accessibility and variety of exchange traded funds and mutual funds available.
Diversification can help investors manage their behavior, so they stick to their investment strategy through difficult times.
Diversification also works because we live in a world where stuff that has never happened before happens all the time.
Don’t get me wrong; diversification isn’t perfect. It certainly doesn’t guarantee a positive return every year. But diversification remains the best avenue for the vast majority of the population to grow and maintain wealth over time.
To the far right of our Asset Class Returns Quilt below, you can see year-to-date returns for the major asset classes.
You’ll see that all asset classes are down except commodities and cash. It’s not fun, but it does happen. The exact reason we stress-test financial plans is for years like this.
There are a couple of silver linings. For bond investors who wanted higher yields (more income), here they are. In January, the yield on the 10-year US Treasury was 1.63%. Today, that same yield is around 3.50%.
For stock investors who wanted a more attractive entry point, the Price-Earnings ratio for the S&P 500 has come down from 21x in January to about 17x today1. Some great companies are now being offered at a more favorable price.
A classic sample 60% diversified world stock/40% US Aggregate Bond mix is down 14.17% year-to-date, its worst year since 2008. Not great, but certainly not catastrophic. This classic example of diversification produced an impressive compound annual return of 6.54% between 2007 and 2021.
It also carried lower risk (standard deviation) than every asset class except bonds and cash.
Slow and steady wins the race.
At our Economic Outlook Breakfast on January 18th, we’ll have more to say about 2022, along with a read on current market and economic data as we head into 2023.
We look forward to seeing you there. If you’d like to attend but haven’t RSVP’d yet, please shoot me an email.
As we close the year, we say a heartfelt thank you for being with us on your investment journey.
Wishing you happy holidays and a prosperous New Year!
Boyd Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
1. JP Morgan Asset Management, Guide to the Markets, 12/12/2022, p.4