So why do we diversify? It seems like such a simple question.
However, when market benchmarks, like the S&P 500, go straight up, it seems some clients (not my clients of course) often forget the answer to this basic question!
Investopedia.com defines diversification as:
“A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.”
“Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.”
I have highlighted what I consider the key phrases in this definition.
Diversification is not about hitting home runs or to be in the best performing index. It is about lowering risk, smoothing returns and hopefully over complete market cycles (5-7 years) raising portfolio performance.
I think this chart shows why diversification is important. (That is unless you have mystical powers and can tell me what asset class will outperform over the next 6 months, 1 year or longer?)
Click to enlarge
Note how the hot asset class in one year, like 2011 where the Barclay’s Aggregate Bond Index was the leader, is often the laggard in the subsequent year.
Alternatively, the laggard in one year many times ends up being at the top or near the top in performance the next year.
It is a common theme!
That is why it is best to diversify over many asset classes. You are not necessarily trying to pick the winners when you do this, you are hoping your winners outperform your losers in a given year and that it produces are return that moves you towards your goals with less volatility.
Now we at InTrust Advisors throw a new wrinkle on this this by adding a trend following model that tracks the broad market index. When that model signals a new bear market has begun, we move client assets to gold, cash or treasuries.
Historically, this has added several percent to annual client returns. It does raise portfolio turnover in the year of the new bear market, but we find most clients are willing to pay a little tax to avoid the next major bear market.