This Level 3 “Broadening Your Portfolio” column frequently deals with specific investments you can add in an effort to increase diversification. But occasionally it’s good to pull back and take a wider view: establishing the value of — and need for — diversification in the first place.
The chart below is a variation of what is often called the “Periodic Table of Investment Returns.” We’ve modified it to include only the five major stock-risk categories tracked by SMI’s Stock Upgrading strategy. The columns show the returns for each risk category for a particular year, with the best-performing group at the top and the worst at the bottom.
For example, the first column shows returns from 2008. The average small/value mutual fund tracked by Morningstar lost -32.5% that year. Each square below that shows the returns of another risk category until you finally reach the foreign funds, which were the worst performers during the depths of the financial crisis, losing -44.4% that year.
The layout of this table is helpful for tracking how specific market segments fared relative to each other over several years. The colors of the boxes help you visually track a particular category from year to year. Without exception, each market segment has gone through years of strength and years of weakness relative to the other categories. All five categories spent at least one year of the past decade as the best performer, and all but large/growth also spent at least one year at the bottom.
(Click Table to Enlarge)
The chart vividly illustrates how the relative performance of particular market segments can be volatile from one year to the next. A great example is the relative performance of the small/value and foreign categories in recent years. In 2015, small/value funds were the worst performers while foreign funds were among the best. In 2016, this reversed strongly, with small/value taking the top spot, foreign the bottom spot, and small/value outperforming foreign by a whopping 25 percentage points! But through eight months of 2017, the script had flipped yet again: foreign was back on top, small/value was the worst, and this time foreign was winning by more than 22 percentage points (+20.5 compared to -1.8).
Many investors, seeing a huge disparity between their results and a particular market segment, start chasing the hot areas. This leads to a never-ending game of catch-up, always trailing the market average as a result of jumping from one sector to another just as it’s about to cool off. Few people can “tune out” the market and ride through the volatile ups and downs that come with being heavily invested in only a single market theme.
The better path for most investors is to spread their money across all of the primary market segments. Yes, this ensures your overall portfolio result won’t match the returns of that year’s hottest performers. But it also ensures you’ll always participate to some degree in each year’s hot area too.
This “spreading your risk” mentality is the essence of diversification, and its real beauty is seen in the fact that it produces long-term returns similar to the individual risk categories while smoothing out an incredible amount of volatility along the way. By muting the sharp ups and downs in your portfolio’s performance, you protect yourself from the most dangerous obstacle an investor faces — your own emotions.
So the next time you wonder if it’s really necessary to own funds in all five SMI risk categories, or you’re tempted to throw caution to the wind and load up on a particular investment type, remember the periodic table of investment returns and the diversification lessons it holds.
It’s said that “fear and greed” drive the markets, and sadly that’s often the case. As an individual, your goal should be to eliminate fear and greed from your investment life. They’re the twin ditches on opposite sides of the road that threaten to wreck your investment journey. Thankfully, a handy set of guardrails labeled “diversification” is available to every investor. Secure those guardrails first and you’re much more likely to enjoy your investment ride.