Diversification – now may not be the time to abandon it

The U.S. equity market (represented by the Russell 3000® Index) has been on a strong run as reflected in the five year returns ending March 31, 2015. While the absolute level of returns doesn’t rival that of the late 1990s U.S. equity market (when returns averaged 26.9% for the last five years of the decade), the return differences between U.S. stocks relative to non-U.S. markets (represented by the MSCI EAFE Index) and U.S. bonds (Bloomberg U.S. Aggregate Bond Index), is among the widest spreads that we have seen in the last 40 years. The dotcom era is the only period that witnessed wider spreads than today. The challenge is, lopsided market results have a tendency to sway investor thought processes – and not always in a good way. For instance when U.S. markets dominate, investors may begin to question the value of diversification and fall prey to two behavioral patterns in particular:
  • home country bias: the investor tendency to allocate a greater portion of their portfolio to home domiciled assets
  • recency bias: the inclination to use recent experience as the baseline for future expectations
Individually, each of these biases can put a damper on financial outcomes. Taken together, they have the potential to set a portfolio back by years.

Risk of investors falling prey to potentially destructive behavioral patterns today?

The question now is: have we hit a point in the market and investor psyche where investors are in danger of falling prey to these behavioral tendencies? It certainly wouldn’t be the first time: U.S. stock market hysteria in the late 1990s tempted many investors to rid themselves of international stocks, real estate and even bonds to focus exclusively on U.S. stocks. Are we in a similar situation again today? At first blush one may think, “no” because we haven’t seen tech bubble-type returns at this point. However, the spread between U.S. stocks and typical portfolio diversifiers (such as non-U.S. stocks and bonds) has been high, even by historical standards. This has caused many investors to question diversification and ask “Why isn’t my portfolio getting the returns I see reported on TV?”

The power of historical perspective

To understand why investors may be thinking this way right now, we put recent results into historical context. In Exhibit 1,
  • We calculated the five-year returns for U.S. stocks, non-U.S. stocks and bonds ending March 31, 2015.
  • Next, we calculated U.S. stocks’ “excess” return for those five-years.
  • We then made the same calculations for rolling five-year periods over a 40-year time horizon ending March 31, 20141 in order to compare the current relationship to historical results.

Exhibit 1

"Sources: Sources: U.S. Stocks: Russell 3000® Index, Non-U.S. Stocks: MSCI EAFE Index, Bonds: Bloomberg U.S. Aggregate Bond Index The five-year results ending March 31, 2015 show a U.S. equity excess performance of
  • 8.1% annualized versus non-U.S. stocks,
  • 10.3% annualized versus bonds.
This excess performance is very strong relative to the 40-year history – which stood at -0.4% on average for non-U.S. stocks and 2.9% for bonds. Focusing in on the most recent 5-year return period, we observe that the U.S. equity excess return relative to
  • non-U.S. stocks exceeded 81% of historical results
  • bonds exceeded 85% of the historical outcomes
These results appear even more one-sided when you combine the excess results of U.S. equity relative to both of these asset classes for the five years ending March 31, 2015. In that scenario, the total excess return (8.1% + 10.3% = 18.3%) exceeded 88% of the previous five-year comparisons. The only five-year periods in which U.S. stocks exhibited greater dominance were periods encompassing the dotcom bubble and current U.S. stock market rally. So, it’s easy to understand why investors may be tempted to succumb to the twin biases of home country and recency: five years is a long time for investors to endure “underperformance” from the portfolio diversifiers outside the home market.

Beware of market whiplash, though

But, investors who give in can get whip-sawed by the market. Market leadership doesn’t last forever and it can swing the other way, often without warning. (see Exhibit 2).

Exhibit 2

Annualized Returns Sources: U.S. Stocks: Russell 3000® Index, Non-U.S. Stocks: MSCI EAFE Index, Bonds: Bloomberg U.S. Aggregate Bond Index. The late 1990s were chock full of investors who started to believe that diversification was dead, and that the road to riches was paved in U.S. stocks. But, once the millennium clocked clicked over, that view was dashed: U.S. stocks posted a negative return during the first decade of the century. Instead, positive returns were found in those asset classes that had been written off during the internet rush to financial independence – bonds and non-U.S. stocks.

The bottom line

The recent U.S. equity run may be a tempting one to jump on. It tugs at some of the behavioral biases that many investors possess, including home-country and recency. Help your clients avoid this trap. While the dominance of a five-year period can mistakenly be forecasted ahead, it is rarely the case that it holds true. Market leadership will turn, as it always does, and those investors who remain diversified will likely be better positioned for the turn – even though diversification doesn’t protect against loss or guarantee a profit.
1 Sources: U.S. Equity: S&P 500 Index from 1970-78, Russell 3000® Index from 1979 to March 31, 2015; Non-U.S.: MSCI EAFE from 1970–March 31, 2015; Bonds: Bloomberg U.S. Gov/Corp Index from 1973–75, Bloomberg U.S. Aggregate Index from 1976-March 31, 2015.The Russell 3000® Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market. MSCI EAFE (Europe, Australia, Far East) Index: A free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.S&P 500® Index: An index, with dividends reinvested, of 500 issues representative of leading companies in the U.S. large cap securities market. Bloomberg U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (specifically: Bloomberg Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index). Indexes are unmanaged and cannot be invested in directly.Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Strategic asset allocation and diversification do not assure profit or protect against loss in declining markets.