Ameriprise Financial : In Defense of Diversification

Diversification is a time-tested, foundational principle of wealth management. Reduced portfolio volatility and downside loss mitigation are bedrock principles of its value. Yet the further removed we get from the type of market conditions in which diversification reveals its value, the more likely we are to question it. We see this pattern of belief, skepticism and abandonment repeated time and again over market cycles. It seemed that we had, once again, arrived at one of those moments towards the end of last year's third quarter, just before the start of the recent selloff in stocks. But the severity and speed of the market decline in last year's fourth quarter seem to have restored some faith in the wisdom of diversification.

Toward the end of last summer, just as the current bull market became the longest in history, we had begun to hear investors question the benefits of diversification, as stocks had risen steadily, with few interruptions, since March 2009. In the language of behavioral finance, this skepticism is attributable, in part, to what is known as recency bias, or the tendency to expect recent trends and conditions to remain in place indefinitely. For some, the pain of the financial crisis, and the damage it inflicted on investment portfolios had remained fresh in their minds, and they maintained steadfast confidence in portfolio diversification. For others, the crisis has been relegated to the history books, an anachronism in today's investment landscape as prices seemingly did nothing but climb.

But a few simple examples may help to illustrate the benefits of diversification. Those with longer memories recall vividly that between October 2007 and March 2009 the S&P 500 fell 57 percent. They likely also remember that the Bloomberg Barclays U.S. Aggregate bond index rose by 7 percent during that same interim. A simple portfolio, diversified equally between these two asset categories, would have resulted in a loss of 25 percent. Painful to be sure, but not the financial disaster that an undiversified exposure to the S&P 500 alone would have inflicted. Yet, once again just a few short months ago, we had begun to hear the voices of frustration with diversification, as the crisis faded further into memory. Investors saw stock prices rising almost uninterruptedly, especially among the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google), and felt left behind. They compared their own portfolio performance to the best performing asset category and wondered why they, too, were not enjoying the same high returns as their neighbor, who of course talks only about his winners, but never his losers.

Through the first three quarters of this year, the S&P 500 was higher by 9 percent in price terms. The Bloomberg Barclays U.S. Aggregate Bond index was down 1.6 percent, leaving that simple, diversified portfolio higher by 3.7 percent. To those who remained mindful of the markets' vicissitudes and the importance of diversification, the simple portfolio behaved as intended, with half the volatility of the S&P 500. To the amnesiac, that diversification acted as an impediment to wealth creation, and their frustration mounted.

From the trough in equity prices in March 2009 through the end of the third quarter of 2018, the S&P 500 was higher by 331 percent in price terms. During that same period, the Bloomberg Barclays U.S. Aggregate Bond index was higher by 40 percent. The skeptic would offer that 291 percent outperformance as proof that diversification was a barrier to wealth creation. However, that cherry-picked time frame is self-serving, as it avoids the prior downturn in stock prices during the crisis. If we do the same calculation from the previous peak in the S&P 500 before the crisis in October 2007, the story is quite different. The price return of the S&P 500 since then was 86 percent through last year's third quarter, still better than bonds as expected, which returned 50 percent. But note, the performance disparity between the two asset categories shrinks dramatically, to 36 percent. This simple exercise illustrates the second benefit of diversification, namely lower portfolio volatility. While the all stock portfolio would have returned 86 percent from October 2007 through the end of last year's third quarter, compared to a 68 percent return from a portfolio equal weighted between stocks and bonds, it would have done so with 60 percent higher volatility. The blended portfolio delivered a performance that was demonstrably less anxiety inducing, likely mitigating the risk of making an emotionally driven decision that would have been counterproductive, including possibly exiting the market altogether and missing the subsequent recovery.

The examples above examine the period ending with last year's third quarter, at the height of the recent skepticism regarding the benefits of diversification. Not surprisingly, however, those voices have since become more muted after the sharp declines of the fourth quarter, when the S&P 500 lost 14 percent, led by declines in those same FAANG stocks. During the same period, the Bloomberg Barclay's U.S. Aggregate Bond Index gained 1.6 percent. Suddenly, diversification looks a little wiser. For the full year 2018, the all stock S&P 500 portfolio lost 6 percent, while the bond index was unchanged, delivering a diversified blended return of -3 percent, or half the loss of the all stock portfolio. And if we go back to the October 2007 peak for stocks prior to the financial crisis, the picture becomes even more compelling. From that point through year-end 2018, the S&P 500 rose by 60 percent. But the Bloomberg Barclay's U.S. Aggregate bond index rose by a comparable 52 percent, meaning that a blended portfolio over that full-time period would have returned 56 percent, a return quite competitive with the all stock portfolio, but with less volatility and less anxiety.

In some respects, the concept of diversification is similar to insurance. No one likes to pay the premium for life insurance, but who wakes up every day upset that, once again, the policy did not pay off? The peace of mind that comes from simply having that policy in place, knowing that one's family will be well taken care of, is comfort enough, and worth the price of the premium, not to mention the relief that comes if and when it is needed.

Which brings us back to today. No one knows when the current bull market in stocks will end. But we do know that someday it will. It is already the longest in history. But we are beginning to see on the horizon some early signs that the current environment is becoming more challenging. The Federal Reserve is raising interest rates to prevent the economy from overheating, slowly tightening financial conditions. The U.S. economy is currently enjoying a growth spurt as a result of fiscal stimulus. But that stimulus is expected to diminish toward the end of this year, and the economy will likely slow along with it. At the same time, corporate earnings growth has surged, contributing to higher equity prices. But earnings growth is expected to decelerate this year to perhaps less than half of last year's pace. And global economic growth also appears to have peaked. All of which may suggest that we are closer to the next point in time when the merits of a well-diversified portfolio will once again become self-evident.

Important Disclosures:
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.
Past performance is not a guarantee of future results.

The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).

Diversification does not assure a profit or protect against loss.

The information and opinions in this article are compiled from third party sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Ameriprise Financial. The information is not intended to be used as the sole basis for investment decisions, nor should it be construed as advice designed to meet the particular needs of an individual investor.

Indexes are unmanaged and are not available for direct investment.

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