Realistic Expectations for a Well Diversified Portfolio
Many investors gauge the performance on their portfolios from nightly newscasts that broadcast the returns on US equities. Over the past 3 years, US equities have generally been the best performing market in the world. During the past year, the Dow Jones Industrial Average gained 7.52% while the broader S&P 500 index rose 11.47%.
In contrast, over this same time frame, well diversified portfolios have delivered very modest returns. The reason for this gap in performance is rather simple. Over the past few years, most asset classes have produced flat or negative returns. For example, foreign stock performance, as measured by the MSCI EAFE, declined 4.9% in 2014. Even among US equities, there were significant disparities in performance as the Russell 1000, a measure of performance of small cap stocks, produced a return of only 4.89%. Last year with the exception of long term bonds that benefited from declining interest rates, returns on fixed income markets were flat. Finally, most alternative investments including gold, long/short strategies and global macro tactical allocations produced lackluster and/or declining returns.
The primary goal of diversification is capital preservation through the reduction of risk. If done properly, the portfolio will look vastly different from one that invests in a single asset class such as large cap stocks. Successful diversification requires allocations to a wide range of asset classes that have low correlations to each other. The goal is to reduce portfolio volatility by investing in asset classes whose returns tend to diverge in various economic environments. It should be noted and expected that often in the short run, the performance of a well diversified portfolio may be significantly lower than the return on a large and single asset class which is precisely what occurred in 2014.
No asset class out-performs all others for long periods of time. Throughout market history, there is a reversion to the mean as performance on appreciating asset classes subside and under performers rise as investors migrate toward these perceived opportunities. Since US equities have been outperformers for a long period of time, it is likely that the baton will soon be passed to another asset class that is currently out of favor.
It is also important to acknowledge that successful asset allocation cannot insulate a portfolio from risk but only reduce it. And in some rare cases such as a financial crisis, it may not work at all. In 2008, correlations between all asset classes tightened and aligned due to chaotic markets and all assets declined in lock step. In these rare instances, cash often represents the only safe haven.
Similarly, asset allocation cannot guarantee superior results. However, if the objective of reducing volatility is met over the long run, portfolios should produce more consistent returns. While many investors may be disappointed they have not fully participated in the ongoing bull stock market, they should be reminded that performance is measured over the long term and not in one year intervals. After all, long term investing is a marathon and not a sprint.
In summary, long term investors who adhere to the concept of diversification have to accept that their investments may occasionally experience lower than expected short term returns. In order to achieve their goals, investors must maintain realistic expectations and remain focused on long term objectives. With a global economy that is more problematic than ever, it is my strong view that the benefits of successful diversification will become even more evident as unexpected economic events unfold that result in increased volatility.
Clifford L. Caplan, CFP®, AIF®
In the News: On December 5th, I was interviewed in the Wall Street Journal in an article titled “Giving the Gift of Money to Loved Ones” where I offered tips to taxpayers who wished to make charitable contributions while benefiting from favorable tax treatment.
Note: For the 4th consecutive year, I have been named a Five Star Wealth Manager by Boston Magazine. While I am honored to have once again been awarded this prestigious honor, it would not have happened without the support of the clients who spoke favorable of me during the interview process. Thank you to all who participated and made this selection possible.