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Why diversification still works

Contributor David Lebovitz


Look back 15 years—a balanced portfolio outperforms its all-equity rival

The past few years have proved difficult for multi-asset investors. Over the long-run, a balanced and well-diversified portfolio has led to better risk-adjusted returns. But recently it has underperformed relative to expectations (blame a strong U.S. dollar, a tepid European recovery and reeling emerging markets) –which has in turn sparked a re-examination of the investing approach. Does diversification still make sense for long-term investors? We believe the answer is an unambiguous: Yes.

Since the U.S. stock market bottomed in March 2009, a balanced investment approach has underperformed U.S. equities. In fact, if one had invested $100 in a broadly diversified portfolio and $100 in U.S. equities at the beginning of 2013, the equity portfolio would have grown to $153 by the end of 2015, but the diversified portfolio would have grown to a mere $118. This has led many to ask whether diversification still “works.” It does, but investors need to understand that if a portfolio is truly balanced and diversified, all of its components will not work at the same time. In bull markets (and the U.S. bull market is now seven years old) stocks should outperform balanced portfolios. If a balanced portfolio is outperforming stocks in a bull market, it probably isn’t balanced!

Diversification means having to say you’re sorry

At J.P. Morgan Asset Management, we often tell clients, “Diversification means having to say you’re sorry.” By that we mean: proper diversification involves owning some assets that will lag when other assets sprint ahead. Some assets will generate positive returns while others generate negative returns, but overall this should lead to a smoother ride. Look at the simple example in the chart below. Here we assume the worst possible market timing: someone invested $100,000 at the 2007 stock market peak into three different portfolios: a portfolio of 40% stocks and 60% bonds (40/60), a portfolio of 60% stocks and 40% bonds (60/40), and a portfolio of 100% stocks.

Exhibit 1: Portfolio returns: equities vs. equity and fixed income blend

Source: Standard & Poor's and Factset; data as of February 29, 2016.

Each of these portfolios lost money during the financial crisis – the question was how much. The 100% stock portfolio lost over half of its value, much more than either of the balanced portfolios. By losing less, the balanced portfolios were able to more quickly recover their losses. In fact, the 40/60 portfolio would have recovered its losses in less than a year and the 60/40 portfolio would have recovered its losses in about a year and a half. On the other hand, it would have taken the 100% equity portfolio three years to recover its losses. So while the balanced portfolios may have underperformed the S&P 500 over the past few years, they significantly outperformed U.S. stocks during a critical period.

Investment implications

Looking ahead, we can say with certainty that there will be another recession (we can’t say with certainty precisely when) and we know that portfolios will need to weather the storm. Diversification is far more important in falling markets than in rising markets, because holding a variety of assets has historically helped minimize losses during bear markets. However, the approach requires that investors sacrifice some performance on the upside. This is why diversification means having to say you’re sorry – by taking action to protect on the downside, one knowingly invests in assets that will underperform on the upside.

Let’s revisit the two portfolios discussed at the beginning of this article. In the 2013-2105 period, the all-equity portfolio significantly outperformed, growing $100 to $153, compared with the balanced portfolio’s $118. However, if we look at performance over the 2000-2015 period, the balanced portfolio has outperformed, growing $100 to $274, vs. $189 for the all-equity portfolio, and doing so with considerably less volatility. Although the past few years have led some to question the merits of diversification, looking back over the market cycles of the past 15 years, its power is undeniable.

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ADDITIONAL DISCLOSURES

The prices of equity securities are sensitive to a wide range of factors, from economic to company-specific news, and can fluctuate rapidly and unpredictably, causing an investment to decrease in value. Investments in bonds and other debt securities will change in value based on changes in interest rates. If rates rise, the value of these investments generally drops. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification among investment options and asset classes may help to reduce overall volatility. Past performance is no guarantee of future results.