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Friday, April 17, 2015

Diversification Under Pressure

Written by  Woody Derricks, CFP®

LPL Financial’s CIO, Burt White, wrote the following letter that helps to explain why so many investors saw returns less than the S&P 500 in 2014:

With any investment approach, it is crucial to have a plan, and the bedrock of any investment plan is to have a well-diversified portfolio among various asset classes. The rationale behind diversification is to mitigate risk, as you never know when something could adversely affect one of your investments. If you had a portfolio concentrated in equities in 2008 or in energy-sensitive securities following the recent drop in oil prices, you would have lost a significant amount of your investment value. As investors, we diversify portfolios to seek to reduce this risk.

 

However, simply because diversification has been an effective way to potentially reduce risk over long periods of time, by definition you would expect it will outperform some years and underperform others. Unfortunately, this can be painful when the outperforming asset class is the most well-known U.S. index—the S&P 500, an index of the 500 largest U.S. public companies. This is exactly what happened in 2014—the S&P 500 significantly outperformed many other often diversifying asset classes, including small cap stocks by nearly 9% and foreign developed stocks by approximately 18%. Therefore, a diversified portfolio last year would have significantly lagged the S&P 500.

So why not just invest in large cap stocks or the S&P 500? Over the past 20 years, the S&P 500 has only outperformed all other major asset classes (including small, mid, foreign developed, and emerging markets) 30% of the time, and it was the worst performing asset class 25% of the time. It is important to stick with your investment plan and be invested in at least several different types of investments. Diversification has historically worked, and as we look at 2015 so far, it may be starting to work again.

In 2015, we will continue looking for places to effectively diversify, and will be closely monitoring potential opportunities. In Europe, the European Central Bank is taking aggressive steps to stimulate its economy. As commodity prices stabilize, emerging markets could join the global growth trend. After decades, Japan emerged from deflation with a massive stimulus effort, which may continue to offer an investment opportunity. There are many potential opportunities on the horizon, and looking ahead, I believe returns may come from a much broader set of investment choices, which has already begun in 2015.

When it comes to investing, it is always important to monitor the risks. A key to risk management is a diversified portfolio. You may not always outperform the most well-known index that many undiversified portfolios emphasize, but that should not lead you to abandon your plan and chase the hot asset class. We remain committed to seeking to outperform in different investment climates, but doing so with a well-diversified portfolio that does not take on undue risk.

According to an April 24, 2014 article on Forbes.com, the average investor is only seeing returns of 2.6% over the 10 years ending 12/31/13. Diversity shouldn’t take the full blame as investors often move out of equities when times are bad or they fear times will be bad then get back in after the markets go up. Find an investment strategy that works for you and stay with it. The more you tweak your strategy, chase returns, or adjust holdings due to fear and greed, the more you may see under performance. While there aren’t any guarantees for performance, patience is often a wise virtue to remember.

Woody Derricks, CFP®

Woody Derricks, CFP®

This article is for informational purposes only and is not intended to provide specific advice to any individual. Consult your legal, tax, and/or financial advisor to determine what is appropriate for your situation. Securities offered through LPL Financial, Member FINRA/SIPC.

Website: partnershipwealthmanagement.com
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