By: Frank Armstrong
By: Frank Armstrong, CFP, AIF
Diversified portfolios are all the rage. After a short absence they have returned to fashion. Now that the Nasdaq is just about the worst performing asset class of all time, and with the mighty S&P 500 slipping into bear territory, it’s easy to see the virtues of spreading risk around the world. Small, foreign and value are looking downright beautiful by comparison. All your friends will agree with the wisdom of a diversified approach.
It was just a year ago that diversification was widely derided. With perfect myopia, commentators opined on the death of diversification, the evaporation of the small cap premium, and the failure of value investing. Critics all but placed Warren Buffett in a home for the infirm.
Keeping the faith
Today, of course, we can see the error of that thinking. But, back then, if you had no investment philosophy or no core beliefs, it was difficult to keep the faith. Until April 2000 lots of people seemed to be getting rich by doing something dumb: concentrating all their investments in a single sector of the world’s economy. The longer that went on, the harder for us to keep ourselves from joining in. It was almost like being continuously tempted by a particularly devious and attractive devil! The temptation to abandon perfectly solid investment strategies at just the wrong moment became too much for many investors.
There was a large measure of not so subtle peer pressure at work. Individual investors or investment advisors that maintained their discipline were accused of failing to grasp the significance of the “new economy”, or considered just too dumb to understand the “new metrics”. Diversification as an investment policy was not a cool topic at cocktail parties. In fact, the underperformance proved temporary. It was a natural, inevitable and expected consequence of the diversification strategy.
This periodic underperformance causes some stress with investors that either do not understand the portfolio design philosophy, and/or who cannot tolerate the social stigma of occasionally underperforming the local index. This desire to look like everybody else’s portfolio is an important psychological impediment for many investors.
Consciously or not, most people and institutions in the US compare their investment returns with the S&P 500. When surveyed, more than a few investors will cheerfully admit that they would prefer an inferior investment strategy to one that caused them to lag their friends at any time! While these investors realize that their constraints are irrational, they cannot accept any investment plan that does not look a great deal like what their friends hold.
Different by design
Our portfolio is deliberately designed so that it won’t (except by pure chance once in a while) track the S&P 500. Our belief, backed by academic research and real world experience, is that a diversified portfolio that overweights small, and value stocks on a global basis will outperform the S&P 500 over time. (We can’t guarantee this, of course.) But, we also know that it will also underperform for some significant periods along the way. (We can pretty much guarantee this!) We cannot diversify and beat the S&P all the time.
Can you dare to be different?
During periods when a diversified portfolio underperforms the local benchmark, maintaining focus requires courage. Human nature being what it is, all their friends will be quick to point out how much better they are doing with their simplistic concentrated portfolios. So, investors need to ask themselves if they can dare to be different in order to obtain better returns over the long haul. If not, they should carefully decide how much diversification from the large US market they can tolerate as they design their investment policy. The time to do this self-examination is now. Otherwise, down the road, those that can’t dare to be different will abandon perfectly good investment plans at just the wrong moment–again!