Risk diversification works, but not always the way investors might want it to.
Diversification is designed both to keep investors out of deep trouble in bear markets and to give them decent exposure to bull markets. It often reflects a middle-of-the-road allocation, helping to control volatility, resulting in an investment journey that is less unsettling when markets turn down.
In bear markets, diversification can be very beneficial. But in up markets, like 2013 and 2014, diversification can contribute to investors feeling left out. When one asset class out-performs, such as the S&P 500 has over the last two years, investors may wonder why they are invested in some asset classes that have underperformed on a relative basis.
To get a look at a typical diversified portfolio, let’s turn to JP Morgan Asset Management’s “Asset Allocation Portfolio” from its Q4/2014 Guide to the Markets. There are nine* asset classes included in this model. As of October 31, 2014 the model had returned 4.8%. However, the S&P was up 11%, while real estate investment trusts returned 23.6%. Investors may have wished they could have concentrated on those two asset classes while avoiding the -6.3% loss for commodities or the -2.4% decline in overseas developed market equities.
While risk diversification is designed to mute gains and losses, it doesn’t have to be a “one size fits all” allocation. There isn’t a magic number of asset classes to own, and one doesn’t have to stick with investments one doesn’t feel have reasonable chances of performing well. The key with risk diversification is to develop a disciplined approach to investing over a range of asset classes, and include some holdings that hedge against your own rationale.
In addition to spreading investments between various funds, risk diversification can also mean being responsive to economic or technical changes by adding or subtracting particular asset classes at different points in time.
One justification for risk diversification is that no one gets it right all of the time. Case in point – ourselves. Coming into this year, we agreed with many other analysts that interest rates were set to rise. We divided our fixed-income holdings between bonds and alternative strategies, with the capability of blunting interest rate increases. When interest rates fell instead of rising, we had enough bonds to benefit from the actual drop in rates, but could have seen better results with fewer alternative strategies. We ended up content with our positioning, however, because the interest rate story could have gone the other way.
In terms of equities, we kept our overweight allocation to US stocks with an emphasis on large caps, dividend plays and cyclical sectors. We also avoided specific investments in commodities, such as oil and gold. These moves proved to be positive contributors to portfolio performance. At the same time, we felt the need to reduce our underperforming international holdings earlier this fall when we changed our outlook on the European recovery.
In other words, our research led us to follow a number of stories, most of which – but not all – panned out. Some positions we stuck with, even if the rationale for ownership was not playing out. This meant owning a fund we didn’t love but recognized as an important hedge. At other times we ended up selling a fund because the story itself became too risky. Throughout the year our portfolio models included a range of asset classes reflecting various economic scenarios.
From 2004 through 2008 JP Morgan’s Asset Allocation Model equaled or outperformed the S&P 500. From 2009 to the present, the opposite was true: the S&P 500 was the clear winner. In investing it is important to remember that losers can become winners, then losers, then winners again. Unfortunately, it is not always easy decipher the full risk story. Hence the need to remain diversified even as a popular asset soars.
*The JP Morgan Asset Allocation Model consists of the 15% S&P 500 (US large caps), 10% Russell 2000 (US small caps), 15% MSCI EAFE (overseas developed markets), 5% EME (emerging markets), 25% Barclay’s Capital Aggregate and 5% Barclays 1-3m Treasuries (US bonds), 5% CS/Tremont Equity Market Neutral Index (an alternative strategy), 5% Bloomberg Commodity Index and 5% NAREIT Equity REIT (real estate investment trusts).
Betsey Purinton, CFP® is the former Managing Director and Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third-party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.