Diversification: Why It’s Hard To Stick With

Have you ever drunk a shot of wheat grass? It tastes absolutely awful. It is extremely good for you, but I never, ever want to try it again. There are many other things that are good for you, such as low-fat, low-salt diets, but most of us would rather eat hot fudge sundaes. I think we should add diversification to the list of things that are good for us in the long run, but not always easy or enjoyable to stick with.

Diversification can make an investor look bad:

2013 was a perfect example of this because an investor could have simply bought the S&P 500 index and earned over 30%. Instead, the prudent, well-diversified investor earned somewhere around 9-14%. Large Cap Domestic stocks (The S&P) have outperformed every major asset class over the past few years. So, why should an investor waste his or her time with “risky” investments such as commodities, real estate, and emerging market stocks?

It turns out that if you look at a longer time frame, such as 15 years, large company U.S. stocks had the worst risk/reward relationship of the 12 major asset classes (see Portfolio Ingredients Chart, below). Commodities, which are perceived by many as risky, had almost triple the average annual return of large U.S. Stocks, with about 20% less volatility (standard deviation) over the past 15 years.

The same is true with emerging market stocks. Sticking with commodities or emerging market stocks as we began 2014 was like sticking to a diet that has not worked for three years when your friend eats whatever she wants and looks great.

The reason many investors have a horrible track record is they chase whatever’s hot at the moment.

Many investors made a big move into emerging markets right after that asset class earned 39% in 2007, only to get decimated by a 53% decline in 2008. A lot of those investors did not stick around to see emerging markets come back strong with a 79% return in 2009. See this chart to see the ranking of asset class performance each year.

The media also causes investors to focus on short-term results and comparisons to the S&P or Dow indexes. If I asked 100 investors, “How did your portfolio perform compared to the S&P 500” many people would have a reasonable guess. What if I asked how your portfolio performed last year compared to commodities? I am sure some people reading this article know that the stock market was down 97 points today. Anyone know what traded commercial real estate did? By the way, traded commercial real estate (REITs) has been the top performing asset class over the past 15 years on a risk-adjusted basis.

What is the point of all this information? Diversification, like diet and exercise, can be boring, but it’s good for you…and it’s not as painful as drinking wheat grass.