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As a financial advisor, at parties and social events, I am constantly regaled by stories of ten-baggers and stock picks that have awesomely outperformed the market and delivered fantastic returns … but today I want to make the case for chasing mediocrity through diversification across asset classes versus attempting to build a portfolio of equity winners, because the hunt for ten-baggers often leads to riskier investments and deep negative returns from time to time that do way more harm to your portfolio than small negative returns in a well-diversified portfolio.
The hunt for ten-baggers often leads to riskier investments and deep negative returns from time to time that do way more harm to your portfolio.
I plan to use some data in my commentary today – and for that – I want to credit Craig Israelsen who wrote an article titled “Are Average Returns Enough for Clients?” for Financial-Planning.com.
Index vs. Diversified Portfolio
In his article, Craig compares annual returns from the S&P 500 index versus an equally-weighted portfolio of seven diversified asset classes over a 44 year period from 1970 to 2013. The diversified seven-asset portfolio consists of large-cap U.S. stocks, small-cap U.S. stocks, international stocks, commodities, real estate, U.S. bonds and cash. The S&P 500 index, as many of you well know, comprises of 500 large publicly-listed U.S. stocks, well-diversified across various industry sectors, but it’s essentially equities only.
The data Craig presented in the article showed that annual returns from the S&P 500 were better than the seven-asset portfolio 55% of the time, with the S&P 500 outperforming in 24 years over the 44-year analysis period – with the S&P 500 sometimes way ahead of the seven-asset portfolio such as in 1998 – when the S&P 500 returned a magnificent 28.6% but the multi-asset portfolio was up only about 1%. Over the 24 years that the S&P was ahead, it beat the multi-asset portfolio by an average of 8.3% per year – that’s a pretty massive margin.
But despite those 24 years of solid outperformance, the two portfolios delivered about the same average annual returns over the 44-year period, with the S&P up 10.4% annually and the multi-asset portfolio up 10.3%.
So what gives?
Turns out, the S&P had nine losing years versus five losing years for the multi-asset portfolio… but the losing years for the S&P 500 were dramatically worse – and the average negative return for the S&P 500 was 15.2% versus 8.7% for the multi-asset portfolio – that’s a difference of 6.5% on average for nine of those 44 years – and that erased almost all of its up year gains.
Now… most of us would likely jump to the conclusion that 24 up years with an average outperformance of 8.3% would easily beat 9 down years of 6.5% annual underperformance… but compounding works a little differently… with negative returns damaging a portfolio way more disproportionately than positive returns… and here’s a simple example.
If you start with a hundred dollars and lose 50%, you’re down to $50… but to get back to $100, you need a gain of $50 on $50… that’s a 100% gain to make up for a 50% loss… so negative gains are much harder to dig out of… do you see that?
So even though the S&P 500 frequently outperformed the multi-asset portfolio, those gains were largely undermined by the frequency and magnitude of its negative returns… and the multi-asset portfolio provided more-or-less the same long-run benefits of equities but avoided the deeper losses of the down years.
Features of a Multi-Asset Portfolio
Investors should also understand that a multi-asset portfolio will never outperform an individual asset class – such as equities – in any given year – so you need to be comfortable with mediocrity and steady gains over flashy returns washed out by horrible years.
Now consider this, over the past 15 years – which were fairly tumultuous for stocks – the S&P 500 delivered a 4.7% average annual return while the multi-asset portfolio was up almost 7%.
And while companies in the S&P 500 do business abroad, have commodity risk, interest rate risk, international diversification, etc., they still all fall within one asset class – large-cap U.S. stocks… so the index offers deep diversification within one asset class – equities. But investors also need breadth diversification for a truly diversified portfolio – and that comes from including different asset classes. With breadth diversification, you avoid the meltdowns of a single asset class such as the three consecutive years of equity losses from 2000 through 2002 or the 37% single-year drop in the S&P 500 in 2008… so while the S&P 500 is an excellent component of a well-diversified portfolio, it alone does not adequately diversify your portfolio… you also need breadth diversification.
And while it’s natural to want to chase top-performing sectors… doing so is really an exercise in folly, which most of us humans are susceptible to until we see the logic of a well-diversified multi-asset portfolio… and I chose this topic today because I thought it was pretty timely… 2013’s been a great year for equities – with the S&P 500 up 32.4% versus a 13.5% return for the multi-asset portfolio – so it’s only natural to want to be in large cap U.S. equities where returns have been fantastic, but I’d urge you to fight that temptation and stick with a well-diversified multi-asset portfolio for the long run… pick the plodding but victorious tortoise over the hare – you’ll sleep better at night and get fairly good returns.