Diversification is Such a Drag ... And That's a Good Thing For Your Portfolio
September 24, 2018
By Michael List, CFP®
Portfolio ManagerTen years ago this month, Lehman Brothers became the largest company in U.S. history to file for bankruptcy protection. News that this 158-year-old giant with over $600 billion in assets had failed, sent shockwaves through the global financial markets. It was also probably the last time most people saw a chart like this:
The quilt chart ranks yearly performance for a broad array of asset classes (unfortunately, crypto-kitties don’t have enough history to make this chart yet). If you select any single asset class, you will find years it performs in the top half and other years when it falls to the bottom half. However, when you follow the diversified asset allocation, you find it is almost always in the middle third.
This is what makes diversification such a "drag" — you don't get as much immediate gratification from the year's best performing asset class (a diversified portfolio just doesn’t hold enough of it). But this also happens to be the best thing about diversification, because the lowest performing class won't hurt you as much. Just imagine if your entire portfolio relied solely on EM Equity back in 2008. Ouch.
There are many levels of diversification. You can diversify with different issuers, sectors, sizes, countries and asset classes, to name a few. But they all have the same effect — a diverse portfolio will protect you from extremes and fall somewhere in the middle.
Through August, three stocks — Amazon.com, Apple and Microsoft — are responsible for nearly 40 percent of the S&P 500’s 9.9 percent year-to-date return. Again, when you are diversified, you won't own enough of these three stocks to realize that return. Although, these three stocks have an average Price-to-Earnings ratio of 75:1 (vs S&P 500’s P/E ratio of 21:1), with a diversified portfolio you own a bunch of other assets that are trading at far more attractive valuations. While valuations don’t make reliable timing signals and don’t provide a guarantee, they are the best predictor of future returns.
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