Diversification Works…Even If You Don’t Want It

By Jon Yankee, CFP®

The turmoil this summer in the investment markets might cause one to think that people have lost money this year in U.S. stocks.  But in fact, most of the U.S. indices are sitting on plus twenty percent gains for the year.

The rest of the world is not doing as well.  Emerging Markets are having a horrible year.  Looking over alternative asset classes, real estate investments are about flat for the year, and commodities are, like emerging markets, are down big this year.  Add those asset classes to the fixed income piece of your portfolio, which is also down, and you have a year that is not too pleasant for a diversified portfolio.

This is the kind of market environment that many professional advisors least enjoy – for a variety of reasons.  First, the turmoil over the summer makes it clear that investors are making investment decisions – and moving market prices – based on emotions rather than logic.  The initial panic following Fed Chairman Ben Bernanke's comments during the summer about ending its QE3 stimulus program seems to have subsided.  But when market values drop precipitously based on a single speech about a hypothetical Fed action that would only be taken due to improved fundamentals, you know that investors are not thinking rationally. 

The other reason professional advisors dislike the current state of the markets is the way diversification looks right now. Whenever U.S. stocks are delivering positive returns while almost everything else – emerging market stocks, bonds, real estate, commodities, and all the other pieces of a prudently constructed portfolio – are going in the tank, investors will ask questions like: "The S&P 500 is up 20% so far this year, but my portfolio is only up 6%.  What are you doing wrong?"

The truth is, no professional can pick the one winning asset out of the myriad of options every year (or half year), and no prudent professional would ever try.  There will always be one asset that returns more than the others, and that winning asset will always be different.  Yet American investors hear about the S&P 500 (and the Dow, and other U.S. large stock indices) on the nightly news, so they are most likely to question the competence (or sanity) of their advisor when the U.S. stock markets are booming and everything else is lagging – exactly the situation we have today.

As most of our clients know, this is the “frame of reference risk” that we discuss often…our client portfolios are very different than most peoples’ context for conversations or current events.  It is the first time since 1998 that we have had such an investment market.  Diversification works…even if you don’t want it to work.

Eventually, some other investment will take the lead, diversified portfolios will look better relative to the U.S. stock indices, and professional advisors will look like geniuses.  That, too, will be a naive view of the situation, but it will be a more pleasant one for those of us who believe in the long-term value of diversification.