It is generally accepted that when it comes to investing – diversification works. The real question is “will you like it?”
By the end of 2014, many investors with sound, properly constructed portfolios were wondering what the heck happened when they kept hearing about what a great year the “market” had. That’s because a “well diversified” portfolio would have had at least 4 or 5 other asset classes besides “Large Cap U.S. Stocks”, the asset class usually referred to as “the market” by mainstream media. And some of those asset classes did not have a good year in 2014, with International, Emerging Markets, and Small Cap equities being some chief culprits. (All of which are performing better than “the market” so far this year – by more than a little bit, incidentally)
So why are we doing this “diversification thing?” (I think I already started the answer…re-read the last sentence.)
The real reason we diversify, without getting “too deep in the weeds”, is because historically, a well-diversified portfolio has usually provided better risk adjusted returns versus one that is not….over time. All things being equal, the more dissimilarity there is among the pattern of returns (from different asset classes), the stronger the effect of diversification – typically being better returns over time with less volatility. But it’s hard to stick with the plan when “everyone in the world” is doing better than you right?
In his excellent book on the subject “Asset Allocation-Balancing Financial Risk”, Roger Gibson talks about “frame of reference” risk.” It’s the idea that the otherwise, “well behaved” investor is at risk because the “frame of reference” is most often the “U.S. Stock Market”, usually represented by its proxies the S&P 500 and Dow Jones Industrial indices… which are indices reflecting the Large Cap Domestic Equity asset class. This “frame of reference” is reinforced regularly in newspapers (or internet versions), on TV, at cocktail parties, and during rounds of golf just to name a few. The normally “well behaved” investor is particularly at risk during periods of superior performance in the U.S. market, because it seems to be all we hear about. The risk is that a good strategy will be abandoned, for fear of being left behind during really good markets.
You have to ask yourself, would you rather follow an inferior strategy that wins when your friends are winning and loses when they are losing, or follow a superior long term strategy that at times results in losing when your friends are winning? I’ve seen plenty of portfolios in my 20 years to indicate there does seem to be some preference for the former. It seems there is not as much “pleasure” in being ahead as there is “pain” being behind.
A good plan, the weight of some historical evidence, and a little discipline should provide the cure, however, in helping you to exhibit the correct “investor behavior”.
Of course, you could try to time the markets….not me though!