I have a good friend who, despite my advice, invests virtually all of his portfolio in an S&P 500 index fund. No foreign stocks, no real estate, no emerging markets, no bonds. Lately, there’s no denying that the US has been the place to be, and just looking at his recent performance, you can almost forgive the heavy concentration in US large company stocks. In fact, the outperformance of the US stock market has been so dramatic in the last few years that many are questioning the wisdom of diversification itself. Why do I own all of these other asset classes anyway?
To address that question, let’s look at some performance data from recent five-year periods. For comparison to the S&P 500, I’ve constructed a well-diversified portfolio containing 60% in equities, evenly split between foreign and US companies, as well as 5% in real estate securities and 35% in global short-term high-quality bonds. This is exactly the kind of thoughtful, balanced 65/35 portfolio we might recommend to a hypothetical client at Vickery. Here is a chart showing relative performance for three different five-year periods from 2001 to 2016:
Period Balanced 65/35 S&P 500
1/2011 – 11/2016 5.0% 11.9%
1/2006 – 12/2010 4.7% 2.7%
1/2001 – 12/2005 7.5% 1.6%
Note that in the most recent period from 2011 until today, the S&P 500 has outperformed the 65/35 balanced portfolio by nearly 7% annually and by a ratio of more than 2 to 1. Moreover, the S&P 500 beat the balanced portfolio every single year in that period, and the last year in which the balanced portfolio did better was 2008! Still, we don’t need to look back very far to find other five-year periods in which the balanced portfolio outperformed the S&P 500, as it did from 2001-05 and again in 2006-2010.
But performance is just one part of the story – the other is risk, and this is where diversification’s role truly shines. Let’s take a look at the same time periods, but instead of returns, let’s examine the volatility (risk) of each portfolio, as defined by the standard deviation:
Period Balanced 65/35 S&P 500
1/2011 – 11/2016 7.6% 12.2%
1/2006 – 12/2010 18.8% 25.4%
1/2001 – 12/2005 14.3% 20.5%
As expected, the diversified, balanced 65/35 portfolio was far less volatile (risky) than the S&P 500 index itself over all three periods. It was about 30% less risky than the S&P 500 even as it delivered higher returns in 2001-05 and 2006-2010. So, before we write off the benefits of diversification, we need to remember that it is an essential element in an efficient portfolio – one that delivers the maximum amount of return for a given level of risk. It also helps to realize that having a diversified portfolio means almost always being disappointed by something you own. At the same time, there is no better way to control risk.
Finally, how long should we expect the current level of US outperformance to persist? No one knows for sure, and markets always have a way of surprising us. What we do know is that the nearly nine-year winning streak for the S&P 500 is unprecedented and has no historical counterpart since the creation of the EAFE index of developed international stocks in 1969. So, while we can’t predict when this streak will end, there is also every reason to believe it is temporary and will turn around eventually. When it does, diversified portfolios will be back in fashion again.