How Diversification Maximizes Your Chance For Long-Term Success

Spread your investment eggs over enough baskets to feel safe? What about when your portfolio lags the market? This is perhaps cause for concern – but not for panic.

Asset allocation constitutes one of the key factors in long-term investment success. When designing a portfolio that meets your risk tolerance, you as an investor need to realize that a portfolio of 50% stocks likely obtains approximately half the gain when the market advances, but suffers only half the loss when the market declines.

This general principle frequently holds true over extended investing cycles, yet can waiver during shorter holding periods. For example, a typical client of mine whose portfolio evenly splits stocks and bonds, saw a return of 3.16% over 12 months ending in October while the Standard & Poor’s 500 posted a return of 11.4%.

My client, logically expecting half the index’s advance, anticipated a return of 5.7% and, using this yardstick, concluded that the portfolio underperformed the market more than 2.5 percentage points during the last year.

Was my client right? Depends on how we define the “market.”

In this example, we use the S&P 500 index to measure how the market as a whole performs. As you may know, the S&P 500 (and the Dow Jones Industrial Average, for that matter) consists solely of large-company U.S. stocks.

A diversified portfolio owns a mix of large-, mid- and small-capitalization U.S. stocks, as well as international and emerging market equities. Comparing the performance of a basket of only large-cap stocks to that of a diversified portfolio comprising a variety of different asset classes is no apples-to-apples comparison.

The S&P offers the kind of benchmarked diversity that often spells success for an investor. Usually a diversified portfolio outperforms the non-diversified large-cap index because several components of the diversified portfolio simply net returns higher than those of large-cap holdings. Not so, of course, when the S&P took a heavy pounding in 2008.

Source: Thinkstock

Source: Thinkstock

And not so during the 12 months that ended in October, when a diversified portfolio underperformed against the large-cap index – and in fact company size and stock performance directly correlated over that time.

  • Large-cap (S&P 500): 11.40%
  • Mid-cap (Russell Midcap, RMCC): 7.08%
  • Small-cap (Russell 2000, RUT): minus 0.49%
  • International (Dow Jones Developed Markets): minus 3.21%
  • Emerging markets (iShares MSCI Emerging Markets, EEM): minus 4.09%

Since large-caps performed best in a diversified portfolio over the 12 months we looked at, in retrospect you might think you missed a superior return from large-cap stocks because you owned (as you probably did) a blend of different equities. Does this mean that owning only large-cap stocks consistently beats a diversified portfolio as an investment approach? Does “diversified” translate to just “diluted” when it comes to your investments?

Of course not. Year after year, we don’t know which asset category will provide the best return; a diversified portfolio gives the best odds that we hold at least a piece of each year’s big winner. Large-caps that won big this year may easily lose big the next.

Don’t be overly concerned if your diversified portfolio underperforms against a non-diversified benchmark over a short period. Long-term results must mean more to you than short-term swings. You can also own a mix of the five classes mentioned above; the majority of them are likely to do well in any given year.

A well-diversified portfolio more likely maximizes your chance of coming out ahead over a long time.

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Written by Lon Jefferies, CFP, MBA. Lon Jefferies is an investment advisor with the fee-only financial planning firm Net Worth Advisory Group in Sandy, Utah. You can find Lon on Twitter, LinkedIn and Google+. Contact him at (801) 566-0740 or lon@networthadvice.com.

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