Another Example Why Diversification Works

August 8, 2017

The last several years were not great for overseas investments as general indices in Europe, Japan and China underperformed for most investors and mutual funds.  When a category struggles in a particular year, the advantage of a diversified strategy (such as the classic 60/40 ratio of stocks and fixed income/cash) often comes into question as there may be years when one or a few asset classes will be average or at the bottom.    What is forgotten is the following year or years, the best ones may be the worst or average and the lagging ones of previous year(s) may now be the best.  The idea is there should be part of the portfolio that does well each year, even if another part does not.  This way, your investment planning remains on track toward your objectives and doesn’t overly suffer in any one year, since losses are harder to recoup.

The “bounce-back” of this idea didn’t really happen for foreign stocks until this year (so far).  Foreign stocks, especially those in so-called “emerging markets” have seen resurgence in appreciation and many have outpaced US domestic markets. This includes US stocks; large, mid-sized, and small.  In fact, some areas of the US domestic market (small company indices and real estate-related investments come to mind, as well as energy) have been fairly tepid in delivering returns to investors so far this year.

Many investors are second-guessing themselves (or their advisors) and questioning their diversification strategy and may now be thinking that international is “the place to be”. I’ve actually had a few clients question why they’re still invested in real estate or energy when returns have lagged the stellar returns thus far in the global arena.  These investors are thinking to abandon real estate and energy and overweight international stocks now.  This could be a mistake.

The truth about diversification, and investing in general, is there are bound to be years when one investment category or sector doesn’t work as well as expected.  In fact, in a properly diversified portfolio for any one year, there will likely be one to a few sectors that will do well, the majority that might perform on average or as expected, and another one or few that will disappoint, sometimes really disappoint.  The key here is that, for the most part, it’s hard to guess, much less know, which sectors will be the stars for the year and which will be the laggards.  Research on these questions shows time and time again, that having your portfolio spread out in an asset allocation format tends to produce satisfactory returns over the long haul, (though nothing is guaranteed, of course).   In fact, making regular contributions to your portfolio amongst all the different sectors, regardless of how they’re doing in any particular year, is generally considered a smart move, since more shares of the laggards are generally acquired at lower prices and less shares of that year’s winners are purchased at higher prices (that old dollar-cost-averaging idea).

Chasing returns is seldom a sound strategy. Stay disciplined, stay diversified, and continue to save towards your long-term financial goals.