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The Importance of Investment Diversification

Investing
We are all prone to a bit of recency bias – focusing on our most recent experiences and losing sight of the bigger picture. That tends to happen in investing too. The past several years has seen great growth in US Large stocks, to the extent they have significantly outpaced other areas. This has led investors to question what works: Why not just invest in the S&P 500? Do I need to own small stocks or international stocks? Is diversification still important? Let’s look at some historical data to see if we can answer these questions.

First, as you can see below, it’s no secret that the large US Large Stocks (as represented by the S&P 500 in dark blue) have been the best performer over the past 10 years (2011-present).They have outpaced US Small stocks (orange), International Large stocks (light blue), International Small stocks (green), and Emerging Markets stocks (pink).

This type of extended good performance is what leads people to ask the questions mentioned in the opening paragraph. We gravitate towards what has worked most recently. That leads to an emphasis on short-term thinking, and we forget what happens over the long haul. Do you remember how stocks performed in the decade before last?

What you see above is almost the opposite of the first chart we looked at from the most recent decade. The S&P 500 severely lagged all these other categories, returning only 15% for the decade (or about 1.4% per year, hardly enough to keep up with inflation). All four other areas of the market outperformed the S&P 500. Especially impressive was Emerging Markets stocks, which were up a whopping 350%. If you only looked at the first chart, you probably wouldn’t imagine that area could have performed that well.

What does this mean in the grand scheme of things? 20+ years is a much more realistic investing timeline than a single decade, so let’s look at how these categories perform over the full period we’ve been discussing.

If you had been holding only one area of the market for 20 years, would you have wanted it to be the S&P 500, which finished 4th of the 5 categories? I wouldn’t!

The reality is, most investors should never own only one area of the market because it exposes them to significant, prolonged underperformance. This is where diversification comes in – you can own all these areas, and while you won’t outperform the best, you will also avoid the worst. Over time, with a bit of patience, this works very well. This can be seen in the final chart below, with a diversified stock portfolio consisting of all 5 categories, highlighted in black.

Over- or under-performance from one area of the market happens constantly and it can last for a long time. Trying to predict these things on a regular basis is both mentally and statistically impossible. Could you have gone all-in on S&P 500 after a decade of underperformance that included two major recessions? I know I couldn’t have.

If you are a long-term investor (which you probably are) the good news is this: you don’t need to worry about trying to predict these cycles. You can diversify your investments to address the unknowns. I can’t summarize it any better than Nobel Prize winner Harry Markowitz did: “Diversification is the only free lunch in investing.” Make sure you have a good investment plan and enjoy the free lunch.

About the Author: Josh Bentz

Josh Bentz, CFP®, Wealth Advisor, helps clients organize and simplify their financial lives by providing comprehensive, personal financial planning. As a Wealth Advisor, Josh provides comprehensive financial planning for clients. He enjoys getting to know individuals and families so he can give specific, meaningful advice. He believes in being a fiduciary and doing what is in the best interest of clients.