Is Diversification Dead?

Is diversification dead? That’s the question. Over the past three or four days, the U.S. stock market has really carried the day. No other asset classes have really done anywhere near the stock market. We have had the longest period in history in which U.S. stocks have outperformed international stocks. Any other asset class you’ve been holding for the last three or four years has more than likely caused your portfolio to lag the U.S. stock market.

So, is diversification dead? I don’t think so at all. But, let’s talk about what diversification is really supposed to mean. Diversification is where you hold different stuff in your portfolio that doesn’t move together. Ideally if one thing zigs, another zags.

If you have a whole bunch of different assets in the portfolio, we really only have about four or five economic conditions we can see move from boom to bust. In any one of those scenarios, there are usually going to be three or four asset classes that are doing well and holding their own. However, since we don’t know when those things are going to happen we need to always own those different asset classes.

In the last three or four years, diversification hasn’t helped much because U.S. stocks have ruled the day. But we cannot lose sight. The reality is over longer periods of time, having some balance in the portfolio makes a lot of sense because it minimizes volatility. Regardless of your age, you should have some eye to minimizing downside risk. Even if you are 20 years-old, and the market is down 40 percent, you need to have some kind of plan to keep that volatility down. As you get older and closer to retirement, you probably want even more balance and diversity, to hedge your losses when the market goes down.

You need to determine what the appropriate asset mix is in terms of how much appetite you have for risk, and, certainly as you get closer to the income phase of life, where you’re going to be drawing income from your life savings, you have to be a lot more cautious. Most people look at their portfolio and think it’s diversified. However, when I put most portfolios into my tools and analyze them, I find they are just betting on the stock market. Even a 60-40 mix of stocks and U.S. bonds is betting on the stock market. The portfolio is moving with the stock market. It may not be moving down quite as fast as the market, but it’s largely moving with the market, making it a bet on the market.

So how much do you want to hedge to provide balance? Here’s a good way to ask it. At this point in your life, would you rather have steady growth or volatile growth? That’s what you have to ask yourself and balance those things. We’re always balancing risk versus reward and how much we want to stabilize returns. If you are always going to own two, three or four things that are doing pretty well, then that means you are probably going to have two, three or four things that aren’t doing pretty well. What ends up happening is you make less in a good market, but you lose less in a bad market. That should be a very important part of your retirement income plan.

In summary, diversification is absolutely not dead.