Why is Diversification Undervalued When It’s Needed The Most?
With the U.S. markets reaching all-time highs recently investors may begin to question traditional investment wisdom and just buy whatever is “hot” and throw diversification out the window. If U.S. large-cap stocks are outperforming other asset classes some investors may be inclined to forget about risk and downside potential and just own U.S. stocks. In positive markets, it can be easy to forget why it is essential to hold a diversified portfolio containing U.S. and international bonds, U.S., international and emerging market stocks, cash and some alternative investments like real estate and commodities.
Many investors remember that the S&P 500 lost 39% of its value in 2008, but only a few recall that the 10 – year government bond gained 21% that year. While the 10 – year bond may not be an exciting investment, a balanced portfolio of both stocks and bonds held up much better in 2008 than holding only stocks.
Many investors may now question their emerging market holdings when looking at the sector’s 6% loss so far in 2018. Investors may also remember that emerging market stocks lost 53% in 2008. But few recall that emerging market stocks gained 40% in 2007, 79% in 2009 and 38% in 2017. With corporate high-yield bonds returning close to no return so far in 2018 it may feel like it’s time to sell those bonds and buy more stocks. However, in the current market cycle since 2009 these bonds have returned an average of 10.8%.
During happy times in the stock market, it can be easy for intelligent investors to forget why they should continue to hold a well-diversified portfolio of strategies and asset classes. Much like a Broadway play, each contributor plays a different but pivotal role in the overall performance, and each plays that role only at the appropriate time. With a diversified asset allocation strategy, some asset classes will always seem boring or unessential at times.
This is how we know that we are managing downside potential. This is how we know that our financial legacy is not at risk. And this is how we know that we are positioned to prosper through any inevitable market downturn.