Does diversification still make sense for U.S. investors?

Although there are countless strategies, theories and approaches to investing, there is one concept that nearly everyone tends to agree on: The value of diversification. Simply put, diversification is rooted in the notion that you do not want to “put all your eggs in one basket”—because what if that one basket fails. When it comes to investing, this means that a multi-asset portfolio—made up of a variety of asset classes—is typically less risky and may have higher returns over longer time periods, than a portfolio that is concentrated in one individual area of the market.

Diversification sounds great—but isn’t always easy to stick to

Sound as the theory appears, it’s not always easy to stick to the strategy. Case in point: many U.S. investors have questioned the value of owning anything other than U.S. stocks as they’ve watched the U.S. stock market (Russell 3000® Index) repeatedly reach new record highs over the last few years and beat all other major asset classes. If your experience and view is like the chart below, then diversification seems like a losing strategy. Source: Russell, Bloomberg, MSCI and FTSE NAREIT. U.S. Equity—Russell 3000® Index; Non-U.S. Developed Equity—MSCI EAFE; Emerging Markets—MSCI Emerging Markets; U.S. Bonds—Bloomberg U.S. Aggregate Bond Index; Global real estate—FTSE EPRA/NAREIT Developed Index; Commodities—Bloomberg Commodity Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Nothing lasts forever

The key is to assess the data from various angles. One cut of the data—in this case, annualized returns—doesn’t tell the whole story. Calendar-year returns lead to a different conclusion, as the chart below illustrates. As of September 2017. Source: Russell, Bloomberg, MSCI, FTSE, Bank of America/Merrill Lynch, S&P. U.S. equities—Russell 3000® Index; International Developed equities—MSCI EAFE; Emerging Markets: MSCI Emerging Markets; U.S. Bonds—Bloomberg U.S. Aggregate Bond Index; Global high yield—Bank of America/Merrill Lynch Global High Yield Index; Global real estate—FTSE EPRA/NAREIT Developed Index; Commodities—Bloomberg Commodity Index; Global infrastructure—S&P Global Infrastructure Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly. This chart offers a slight twist on the classic quilt chart of asset class performance. Rather than stack-ranking asset class performance for a given calendar year relative to zero, this chart illustrates the returns of various asset classes relative to the U.S. equity market (highlighted in the center of the chart). So, any asset class that appears above U.S equity outperformed for that calendar year, while any asset class that appears below U.S. equity underperformed for the calendar year. This chart also helps remind investors that it wasn’t that long ago when U.S. equity was not a very popular place to invest. From 2000–2007, U.S. equities consistently trailed most other asset classes. U.S. equities experienced a particularly rough patch from 2002–2006, underperforming International Developed Equities, Emerging Markets Equities, Global Real Estate and Global Infrastructure in every calendar year. This underperformance has caused many people to refer to 2000–2009 as the “Lost Decade” for U.S. equity investment returns. Diversified investors were rewarded, though, as other asset classes earned positive returns in this time period, with some asset classes more than doubling in value, as the table below shows. Emerging Markets Equity: MSCI Emerging Markets; Global real estate—FTSE EPRA/NAREIT Developed Index; Commodities—Bloomberg Commodity Index; Global high yield—Bank of America/Merrill Lynch Global High Yield Index; U.S. Bonds—Bloomberg U.S. Aggregate Bond Index; International Developed Equity—MSCI EAFE; U.S. Equity—Russell 3000® Index; Global infrastructure—S&P Global Infrastructure Index.Source: MSCI, FTSE, Bloomberg, Bank of America/Merrill Lynch, Russell, S&P. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

Diversification outlook

At the end of the “Lost Decade,” it would have been tempting to reduce or even eliminate U.S. equities from portfolios based on their track record over the previous 10 years. However, that decision would have been costly over the next few years. Similarly, many investors who chose to reduce non-U.S. equity allocations have suffered so far in 2017. Despite strong returns of 14% for U.S. equities year to date as of September 2017, they have trailed Emerging Markets equities, International Developed equities and Global Infrastructure which have gained 28%, 20%, and 17%, respectively. So, the theory of diversification still holds: not a single asset class can consistently outperform; market leadership rotates in unpredictable cycles among asset classes.

The bottom line

A globally diversified multi-asset portfolio is designed to help investors avoid the common pitfall of chasing recent returns and moving into or out of an asset class at exactly the wrong time. Market leadership can change abruptly and when it does, diversification—even though it doesn’t assure a profit or protect against loss in declining markets—remains one of the best ways to manage through market swings.