Is diversification dead?

‘Sometimes you have to use your failures as stepping-stones to success. You have to maintain a fine balance between hope and despair.’ He paused, considering what he had just said. ‘Yes’, he repeated. ‘In the end, it’s all a question of balance. – Rohinton Mistry, A Fine Balance

If you follow my blog long enough, you will come to find that I read a lot.  I am one of the few people I know that has a goal for the number of books to read in a year.  I think I’ll achieve my goal of 50 since I’ve already read 5 in 2015.  I read mostly fiction novels as I think I read enough news and reality on a daily basis.  I have 3 Kindles and each of them have a specific purpose plus my iPhone, iPad, desk top computer, and lap top have the Kindle App on them so that I am never far from my library.

The quote above is from a book I read 12 years ago.  The book made me very angry and I swore off Oprah’s Book Club from then on and I have kept my promise.  I have purposefully avoided books with her stamp of approval on them due to this book alone.  Maybe that’s an unfair assessment, but the book was powerful that way.  This 600 plus page novel is set in 1970’s India and the end was just devastating.  I’m not saying I want the “they lived happily ever after” ending for every book, but for Pete’s sake!  Give these characters a break for a half of a second.  But as we all know, life doesn’t always work out the way we planned.  Though it was masterfully written and honest, I was so depressed when I finished reading it.  It really put me in a funk and as you can see, 12 years later, I still remember it.  Maybe one day I will read the book again since I am a different person than I was 12 years ago.  This book did give me something I was not expecting…gratitude, humility and perspective.  We have it really good here in the US and this book opened my eyes to a lot of things that I take for granted, such as running water, flushing toilets, and electricity.  My first world problems are insignificant in the scheme of things.

Now on to the purpose of this missive…diversification and finding a balance.  The past 3 years have seen above average returns in the US markets, particularly Large Cap Growth.  The 20 year annualized return of the Large Cap Growth sector is 8.52% (MFS Research, as measured by the Russell 1000 Growth Index).   The returns in this space for the past 3 years are as follows:

2012: +15.26%

2013: +33.48%

2014: +14.25%

That equates to 20.55% annualized returns over the past 3 years (Russell.com).  This is all good, right?  Yes. And no.  Yes, because this means the US markets and economy are doing well.  No, because it gives us unrealistic expectations for our portfolio returns.  Let’s take a stroll down memory lane continuing with the Large Cap Growth sector as our proxy and $10,000 as our hypothetical investment.

1996:  +23.12%                 Year End Value = $12,312

1997:  +30.49%                Year End Value = $16,605

1998: +38.71%                  Year End Value = $22,285 (already more than double the original investment!)

1999: +33.16%                  Year End Value = $29,674  (almost a triple!)

These massive returns were fueled primarily by Dot Com and Tech stocks.  In 98 & 99, this asset class was one of the top performing sectors.  Then what happened?

2000:  -22.42%                Year End Value $23,317

2001: – 20.42%                                Year End Value $18,556

2002: -27.88%                 Year End Value $13,382…cue the SNL Debbie Downer music.

This particular asset class went from the top performer to one of the worst performers.

Funny things happen with the markets…they can do the unexpected without much warning.  In 1999, the fervor over tech stocks created euphoria among investors causing them to throw caution to the wind and believed their 20% returns were normal.  Diversification was thrown away as though it was dead, because why do you need diversification when things are going so well?

Let’s look at a more balanced approach.  If you had invested that same $10,000 into a Diversified portfolio consisting of equal weightings in Large Cap Value, Large Cap Growth, REITs, Bonds, International Equities, Global Bonds, Small/Mid Cap Stocks, and Commodities, you would have ended up with $15,682 during that same time period of 1996-2002 (MFS Research).  The annual returns being 16.89%, 14.55%, 6.19%, 13.07%, 5.23%, -4.98%, and -2.53% in chronological order.  The ups weren’t as high, but the lows weren’t nearly as low.

Would you prefer the end result of the Large Cap Growth Only portfolio or the Diversified one during this period of volatility?  Let’s dive a little deeper than returns alone.  The other component is risk.  In the investment world there are several ways to measure risk, but for this we will brush up on statistics and use standard deviation.

Define: Standard Deviation: 1. A measure of the dispersion of a set of data from its mean.  The more spread apart the data, the higher the deviation.  Standard deviation is calculated as the square root of the variance.  2.  In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment’s volatility.  Standard deviation is also known as historical volatility and is used by inve3stors as a gauge for the amount of expected volatility.

Thank you, Investopedia for that succinct definition.  To put it bluntly, when comparing the standard deviation of a set of investment options, the higher the number, the more volatile the investment should be.  The lower the number, the less volatile the investment should be.

Remember these bell curves?

bell curve

The dark purple area represents 1 standard deviation away from the mean.  So if your mean is 8% and your standard deviation is 10, that means that 68% of all results will fall within -2% and +18% or one standard deviation away from the mean (Source: any statistics text book).  2 standard deviations away from the mean will include 95% of the results and 3 standard deviations represent 99.7% of the historical returns.  Do you know what 2008 was in terms of standard deviations from the mean?  It was above 2 but not quite 3.  Do you know what 2013 was in terms of standard deviations from the mean?  The same as 2008, but just in the opposite direction.  Volatility doesn’t mean negative.

Now let’s apply standard deviation to the sets of data above.  The Large Cap Growth asset class has a standard deviation of 17.46 with a mean return of 8.52% over the past 20 years.  The Diversified Portfolio has a standard deviation of 10.57 with a mean of 8.42% (MFS Research).  So in the case of the Large Cap portfolio, you have a 68% chance of achieving portfolio returns between 25.98% and -8.94%.  In the Diversified Portfolio you have a 68% chance of achieving portfolio returns between 18.93% and -2.15%.  Lower highs, but higher lows with the diversified portfolio.  At this point, I am hoping that I haven’t lost all my readers with the abundance of numbers and mathematics, so I will attempt to bring this full circle and save some other thoughts on behavioral finance for next week.

With the above average returns we have experienced over the past few years in the US markets, it is easy to get disappointed with portfolio returns that are not double digits.  However, I caution this thinking.  Double digit returns are not the norm nor do they come risk-free.  There is no guarantee that diversification will work.  There is no guarantee that by the time this blog post is approved by compliance and posted that there won’t be another terrorist attack post-Charlie Hebdo.  There is no guarantee that I have a tomorrow.  But, with history as a guide, I urge a fine balance between risk and reward.  Optimism and pessimism.  Hope and despair.  Skepticism and conviction.  I truly believe that long term investing requires such a mindset and not getting caught up in the hype.  Going too far in one direction or the other can cloud judgment and cause higher than normal risk taking potentially resulting in greater loss.  Greed is a deadly sin for a reason.  So to answer the title of this article…no, I do not think diversification is dead.  It is doing exactly what it is meant to do.

Questions?  Comments?  Thoughts?  Ideas?  I’d love to hear them.

Until next time,

Carolyn Menker

LPL Wealth Advisor

Williamsburg Financial Group

cmenker@williamsburgfinancialgroup.com

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. Indexes are unmanaged and cannot be invested into directly.

Economic forecasts set forth may not develop as predicted.

All investing involves risk including loss of principal.

Because of its narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.