The S&P 500 index ran up nicely in 2016—up almost 10%. Small U.S. stocks were up around 20%. Emerging market stocks recovered well from dismal performance in 2014 and 2015. Bonds and developed international markets stocks, not so much. The US bond market had a relatively disappointing year—up less than 3%.
Go ahead and admit it--you begin to question why your portfolio is diversified, or you wonder whether it's diversified appropriately—when you see specific securities or indices go up more than your portfolio.
We've been schooled to appreciate diversification from even a young age. Grandma used to say, "Don't put all your eggs in one basket." Endorsements of the concept are many. Indeed, a leading voice within the financial services industry, author and investment advisor Barry Ritholtz, states "The beauty of diversification is that it's about as close as you can get to a free lunch in investing."
One problem is that like eating spinach, going to the gym, and flossing our teeth, we don't see immediate payout from diversification. And as 2016 illustrates, diversification often means that there are segments of your portfolio that disappoint. Someone has said, "Diversification means there's always a part of your portfolio that you hate." Finally, mental accounting about our portfolio is all about growth and performance—not the reasons we diversify. Few of us brag about how steady and boring our portfolio is.
So, why do we subject ourselves and our portfolios to diversification?
Reason # 1: The climb back is harder than the fall down. We invest in a single investment, and it falls 20%--we need it to grow 25% to get back to where we started. If our portfolio craters, gets cut in half, we need a gain of 100% to get back to where we were. Diversify the portfolio with non-correlated assets—investments that don't react to market forces in the same fashion. That reduces the potential for a major drop in the value of our holdings. We're less likely, then, to need a major recovery (which may take years to arrive) to get back to where we started. Diversification is like putting bumper cushions along the side of the bowling alley—it helps keep you from getting too far out of bounds. It's a matter of safety.
Reason # 2: Trying to predict the markets is a lesson in humility. The start of the New Year brings so-called experts making calls on what the markets will do in the coming year. You know where I'm going with this point. Warren Buffet said it well: “We’ve long felt that the only value of stock forecasters is to make fortune tellers look good.” His comment applies as well to those who try to predict asset class movement over a year. If timing the market worked, wouldn't market timers be on the Forbes list of billionaires? They're not.
Reason # 3: Diversification expands our investment horizon. Millions of consumers in the emerging market economies, for example, buy from companies not well known by the American public. Profits will follow. Is there a place in your portfolio for funds that invest in profitable companies that you may not know well? Maybe there should be. According to the World Bank, the U.S. share of world gross domestic product in 2015 was less than 25%. He who only eats one cuisine, Raman noodles for example, may not starve, but deprives himself of the riches of a varied diet.
Diversification can be carried to an extreme; we're not promoting it without recognizing that it needs to be done carefully and appropriately. But the next time you look at your portfolio and question its composition, remember why you diversify: safety, the difficulty of making accurate short-term market calls, and expansion of opportunities to invest.