In team sports, it’s important to have players who complement each other’s skills. If a baseball team was stocked exclusively with relief pitchers, it would be unlikely to win a single game! The team’s risk of losing goes down as it adds strong starters, top-notch hitters, and solid fielders.
Investors would be better off if they built their portfolios the way managers assemble teams — with an eye toward diversifying their talent so they can compete effectively under a variety of conditions.
Sound Mind Investing enters its 30th year this summer, and over those three decades, we’ve seen a wide variety of market environments. We’ve watched the stock market soar in the dot-com bubble of the late-1990s and crumble in the -50% bear markets of 2000-2002 and 2007-2009. We’ve seen a real-estate bubble and subsequent bust. We’ve watched gold and other precious metals slumber for a decade at a time in the 1990s and 2010s, punctuated by a wild rally during the 2000s. And after watching bond returns pour in at a rapid clip as interest rates declined throughout the 1990s and 2000s, we’ve also watched investors starved for income as interest rates were dropped to historic lows and kept there for much of the past decade.
Throughout these ever-changing market conditions, the key to SMI’s success has been keeping our focus on three fundamentals: strategic selection of top-performing funds, broad diversification across many asset classes, and having the self-discipline to stay with our strategies through the market storms. We’ve written frequently in past years on the first and last of these factors; we think it is timely now to devote an article to the importance of the second.
Why timely? Because of the fact that the past decade has been “the worst of times” for diversified portfolios, at least relative to the S&P 500 stock-market index. Investors who have diversified into virtually anything else since this bull market began in 2009 have earned lower relative returns. Meanwhile, the ride higher has been smooth enough (with a few notable exceptions in 2011, 2015-16, and late last year) that investors heavily exposed to equities haven’t incurred much of the normal volatility “cost.”
Now, after a decade of seemingly getting a free ride in an exceptionally performing S&P 500, many investors understandably may be casting a skeptical eye toward diversification. This article is intended to go back to basics and re-establish the value of this crucial investment principle. Unfortunately, it’s those times (such as the present) when investors most need sound diversification that they’re most likely to abandon it.
Our collective memory of horror stories about people who saw their retirement and other investment accounts shrink by 50%, 60%, or more during the past two bear markets is fading. But if you could examine those portfolios, we suspect you’d find that somewhere along the way those investors stopped spreading their risk through diversification and began concentrating their holdings too narrowly. When the market turned, they had no exit strategy and rode their investments down.
Diversification is a key biblical investing principle
We believe that, ultimately, it’s impossible to self-destruct financially if you follow God’s time-tested principles for stewardship. One of those principles is that, to protect against the uncertainties of the future, your investments should be broadly diversified: “Give portions to seven, yes to eight, for you do not know what disaster may come upon the land” (Ecclesiastes 11:2). To diversify is to be honest with yourself and say, “Not only do I not know what the future holds, none of the experts do either.” Since you don’t (and can’t) know the future, you can never know with certainty which investments will turn out most profitably. That’s the rationale for diversifying — spreading out your portfolio into various areas so you won’t be overinvested in any hard-hit areas and you’ll have at least some investments in the most rewarding areas.
What we’re going to do in this article is build a portfolio, piece by piece, and illustrate the effects that diversification has on risk and return. The idea is to pick investments that “march to different drummers.” This means your strategy involves owning a mix of investments, a variety of holdings that tend to respond in different ways to economic events. You will see that as we add various kinds of assets into the mix, the volatility of the portfolio is gradually reduced. Surprisingly, it’s possible to assemble some lower-risk investment combinations that give similar returns over time as higher-risk ones! Such a mix of investments is said to be more “efficient” because it accomplishes the same investment result while taking less risk.
The portfolio we’re constructing here is being built for the sole purpose of illustrating the impact of diversification. Don’t be confused by the fact that it doesn’t precisely match any of SMI’s specific investing strategies. If you follow the SMI strategies, you’ll be getting a healthy dose of diversification, the level of which will vary depending on which (and how many) strategies you include in your portfolio. (For a view of the impact of diversification among specific SMI strategies, see Higher Returns With Less Risk, Re-Examined.)
Building a model diversified portfolio step by step
We’ll launch our imaginary portfolio at the beginning of 1989 (30 years ago) and initially put all our money in mutual funds that invest in small companies experiencing rapid growth. The idea here is that these companies have the best growth prospects, so an investor might reasonably assume they are likely to earn the highest returns.
Our initial portfolio looks like the one shown above. (Note: All returns in this article are based on the average returns of all mutual funds in a given category.) Small-cap-growth funds as a group returned 10.23% annually, on average, during the 30-year period that ended 12/31/18. This is slightly better than the 9.93% turned in by the overall market (as measured by the Wilshire 5000 index) during that period. However, the above-average returns come at a cost: the “relative risk” score is 1.38, meaning that the month-to-month volatility of the portfolio is 38% greater than that of the market taken as a whole. (By definition, the market’s volatility in this calculation is 1.00.)
To reduce our risk, let’s move one-half of our money into growth funds that invest in larger companies such as those found in the S&P 500 stock index (Portfolio B). The average large-growth fund returned 9.09% during the test period. The lower return is not surprising. Since the growth prospects for large companies aren’t as great as smaller companies, we would expect to earn a somewhat lower return as a result.
This change causes the average annual return of our portfolio to fall to 9.76%. (Note: Because portfolios are rebalanced regularly, the 30-year results are not the same as simply averaging the various components.) What we gain, however, is more stability — now the portfolio is only 21% more volatile than the market (relative risk of 1.21). But we can improve on that.
So far, we’ve been concentrating our money in growth-oriented funds. There’s a more conservative approach to picking stocks called “value investing,” and many mutual funds specialize in that area. Value investors are bargain hunters, seeking out companies whose stock is underpriced due to (hopefully) temporary factors. During the 30-year test period, small-company value funds returned 9.95% and large-company value funds returned 8.50%. Further dividing our portfolio so as to include equal allocations to these value-oriented funds (Portfolio C) is a win/win tactic.
For one thing, we further reduce our portfolio’s relative risk — it drops to 1.06, only a little higher than the market overall. We would expect this, since we’re now equally divided among the four primary asset classes that make up the U.S. market. Second, our average annual returns decline only slightly, despite the fact that value funds have lagged growth by a wide margin over the past five years. Over longer periods, value managers have a history of slightly outperforming their growth-oriented rivals, so we’d caution against reading too much into the slight performance decline in this recent period.
The bigger takeaway regarding growth vs. value funds is this: there are periods when growth funds dramatically outdistance value funds and vice versa. We’ve written about some of the similarities between the current market and that of the late 1990s. This is another: just as growth has outperformed value the past five years, the performance gap was even more striking in 1998-1999 when it was +76% for growth funds versus a meager +7% for value funds! Since you can’t know with any degree of certainty when these episodes will occur, the safest (and easiest) thing to do is always be invested in both groups.
Now that we’ve covered the U.S. market, let’s consider adding a foreign flavor. International diversification was long viewed as a strong diversification move, as other country’s economies and markets often moved out of sync with the U.S. However, as the global economy has become more thoroughly integrated, world markets now seem to rise and fall almost in lock-step with ours.
As can be seen in the Portfolio D table, adding a 12% allocation to foreign funds did little to dampen our portfolio’s volatility — the relative risk score barely moved, dropping from 1.06 to 1.04. But, because foreign markets trailed the U.S. in 18 of the 30 years, performance in our portfolio took a slight hit, falling from 9.63% annually to 9.33%. Still, SMI continues to think foreign diversification makes sense and still includes foreign components in most of our main strategies.
In terms of stock-market diversification, SMI’s two original model portfolios (Just-the-Basics and Fund Upgrading) stop here, with a mix of domestic and foreign stock funds. But SMI’s primary defensive strategy, Dynamic Asset Allocation (DAA) includes two additional asset classes: real estate and precious metals.
Looking first at U.S. real estate, it’s worth noting that this asset class has a track record of occasionally zigging when the stock market zags. The Wilshire 5000 index outperformed real estate over the full 30-year period, but real estate was actually the better performer in 17 of the 30 years. Allocating 8% to real-estate funds as shown in Portfolio E resulted in a slight decrease to our risk score and increase to annual performance vs. Portfolio D.
Adding a precious-metals component to our portfolio (see Portfolio F) lowered both risk and returns slightly. Precious metals funds performed rather poorly over the 30-year period as a whole (the period from 2001-2010 was great, but the remaining years not so much). Based purely on past performance, it’s hard to argue that metals are worth adding, at least on a permanent buy-and-hold basis, which is why for many years SMI advised not to bother. But they can be a valuable addition in certain circumstances, which makes them a great addition to DAA where we can own them some of the time without being committed to them all of the time.
We’ve included them here to show that a modest allocation to metals hasn’t been a significant detriment, even during a period that wasn’t especially favorable to them on the whole.
There’s still more that can be done to lower risk, and that involves the most significant diversification move yet — moving some of our money out of invest-by-owning types of mutual funds (the higher-risk kind) into invest-by-lending types of funds (the lower-risk kind).
Portfolio G shows the effects of making slight reductions in each of the equity allocations in order to carve out a 20% position in intermediate-term bonds. Making this change reduces the volatility of our portfolio by about 1/5th (by lowering our relative risk score from 1.01 in Portfolio F to 0.82) while reducing our return only about 1/16th (from 9.32% to 8.72%).
With bonds, it’s always a question of balancing your need for income (longer-term bond funds typically yield more) with your desire for safety (shorter-term bond funds are more stable). SMI’s Bond Upgrading strategy uses a variety of bond types, but for our purposes in this article, using intermediate-term bonds makes sense. Choosing intermediate-term funds is a middle-of-the-road solution that presents something of a “best of both worlds” dynamic. Historically, intermediate-term bonds have been the sweet spot of the bond market, offering most of the extra return provided by longer maturities with only a modest increase in risk.
Review and conclusion
Let’s review. We began our journey with a go-go portfolio made up solely of small-company growth stocks (Portfolio A). Now, we’ve diversified into large companies, value strategies, real estate, precious metals, and bonds (Portfolio G). As a result of these changes, our annual return has declined just under 15% (from 10.2% to 8.7%). But more importantly, our measure of risk has fallen by more than 40% (from 1.38 down to 0.82). The graphs that follow illustrate why, for most investors, that’s a good tradeoff to make.
The first graph (above) shows how a dollar invested in the U.S. market (Wilshire 5000) at the beginning of 1989 would have grown to be worth $17.13 by the end of 2018. The shaded area of the chart shows what the path would have looked like if the portfolio had eliminated all volatility and simply showed the same consistent return, month after month, as it moved toward the $17.13 mark. That’s the ideal — the path we’re trying to move toward with our diversification efforts. That is the path that offers the least volatility, and accordingly, the least emotional stress.
Obviously, the U.S. stock market wasn’t close to that ideal, racing out ahead of the mark during the three major bull markets, then falling dramatically during the two major bears. It’s completely reasonable to expect a third repetition of this dynamic, likely not too many years in the future.
Portfolio A (shown above), with its emphasis on higher returns with small-growth stocks, had an even wilder ride than the overall market. But as we added asset classes on our way to Portfolio G (see series of graphs below), the path gradually moved toward the “ideal” of the smooth line. Yes, the bull and bear markets remained clearly visible, but their impact was less dramatic.
By the time we reached our most diversified portfolio (final graph above), we had done a reasonably good job — our total gains were lower than the overall market (as one would expect from a portfolio with a 20% bond allocation), but not by a huge amount. More importantly, the volatility in this portfolio was reduced to a level most investors could live with.
It’s important to note the stock market is likely nearing the end of the current bull cycle. So the smooth line may be at a “high ebb” — the stock market’s average long-term returns rarely have been as strong as they are today. Following the next bear market, it’s probable the smooth line will retreat more than the diversified portfolios shown in each chart.
Again, please understand that we’re not suggesting you should adopt the “one size fits all” allocation scheme shown in Portfolio G. The process of building the retroactive portfolios in this article was done for the specific purpose of illustrating diversification tradeoffs step-by-step.
For real-world investing, we encourage blending the SMI strategies to whatever degree you’re willing to implement them. Because each SMI strategy is unique in how it chooses investments and diversifies against risk, there’s an additional diversification benefit to be gained by adding more strategies to your portfolio.
However, this needs to be balanced against the fact that implementing more strategies requires more effort. So add only what you’re willing to keep up with and implement well. That said, if we were implementing the strategies for you, all of the SMI strategies would be represented in the portfolio, as they all bring something different — and valuable — to the table.
The main point of this exercise is to drive home the point that maintaining a healthy level of diversification in your portfolio can lower risk without substantially hurting your returns. Many investors who suffered grievous losses in past bear markets lost sight of this; many shifted to a “Portfolio A” mentality in pursuit of greater gains and had no safety net when bear markets took them by surprise. Similarly, many investors today are being seduced by the S&P 500’s strong recent returns and are ridding their portfolio of other investments in pursuit of those higher gains.
Mark Twain is often credited with the saying, “History doesn’t repeat itself, but it often rhymes.” We believe the current market is “rhyming” pretty strongly with the late 1990s bull market, and we know how that story ended. To avoid a similar fate, we encourage you to keep your eye on the big picture: How much money do you have invested in each strategy, and by extension, in each of the various asset classes? A well-diversified portfolio is the best defense against future market storms.