Monday, March 07, 2005

Does Diversification Always Work? Why Most People Would Have Fired Me......

I build diversified portfolio's for my clients. This means that I have my clients buy all sorts of different types of investments. A typical portfolio will have large stocks, small stocks, value stocks, growth stocks, & international stocks along with bonds. Diversification is the bedrock of investing and serves to give you a similar (hopefully better) return than the market with less fluctuation. But does it always work?

No. Diversification doesn't always work. There will be time periods, sometimes long time periods where the benefits of diversification do not seem readily apparent. Between 1995 and 1999 a diversified portfolio drastically underperformed the market. The market, as represented by the Russell 3000 returned an annualized 26.95% between 1995 - 1999, an incredible run. A well diversified portfolio that held international stocks returned about 16% annually, a great return, but over 10% less than the overall market. How enthused with a diversified portfolio would you have been after five years of drastic underperformance? Had you invested $100,000 on January 1, 1995 you would have had nearly $330,000 if you bought the market, but only about $212,000 with a diversified portfolio - a difference of over $100,000 - would you have been happy with this differential? It is entirely likely that you would have already fired me and moved on to an advisor who was willing to put you in what was hot at the time, large cap growth stocks. Let's consider what happened over the next five years.

Between 2000 and 2004 the market as represented by the Russell 3000 returned a negative 1.17% (that is -1.17%) annualized. A diversified portfolio during the same five year stretch annualized a 10.41% return, an outperformance of about 11%. People who invested $100,000 in a diversified portfolio on January 1, 2000 and held till the end of 2004 would have ended up with about $164,000 vs $94,000 with the market strategy. At the end of this five year period a diversified portfolio strategy would have look ingenius.

For the entire ten year stretch the market returned an annualized 12%, with a diversified portfolio a little over 13%. The diversified portfolio had a higher return, but more importantly a more consistent return. The diversified portfolio had only one down year versus three for the market. The market based portfolio fluctuated nearly 30% more than the diversified portfolio. The diversified portfolio had less fluctuation and a higher, more consistent return. In hindsight it is easy to see which would have been better, but while you are in the moment people tend to make decisions based on emotion.

What will the next five years bring us? I wish I knew, unfortunately I haven't located the crystal ball that will tell me. What I do know is that a diversified portfolio should provide much more consistent returns with less fluctuation than the overall market, and with a higher return to boot. We may be in for a time period where the market outperforms diversified portfolios, I urge you to not follow the crowd and do what is easy. Stick with a diversified portfolio and in the long run you will be the real winner. I can't promise we will beat the market in the short term, but in the long term I believe that a well diversified strategy combined with low costs will give you the best chance of success.

Until next time....