Given the stellar performance for the U.S. equities in 2019 many are questioning why we diversify. Below is an article by Frederick C Taylor that explains
Given the media’s trumpeting (OK, Trump himself as well) of the stellar performance of the U.S. market(s) this past year, one might be tempted to ask: why should or do I have any international stock exposure? After all, look how much more I might have made if I were not diversified and only exposed here in the U.S. Moreover, if I am diversified, why should I rebalance my portfolio when I could just keep a larger allocation or even 100% in the “winning” asset class? That is a fair question that demands a factually based answer, so here goes:
Rebalancing a diversified portfolio essentially addresses two very important investment issues:
1. It imposes a discipline on the portfolio of buying “low” and selling “high” and, after all, isn’t that the old Wall Street dictum of how you make money in the market? This isn’t rocket science and just about any individual with an IQ above room temperature knows this. It’s not the knowing part that’s difficult, it’s the discipline to sell someof those better performing ones and buying those that others find unfavorable at this particular time. This, of course is the emotional part of the equation and where the “discipline” comes into play.
2. There was a landmark study as to where portfolio returns came from. I don’t expect most readers to have any familiarity with it (unless you were taking notes at one of my presentations or read my writings very carefully with a fully retentive memory). The study showed that 94% of a portfolio’s return was due to it’s asset allocationpolicy. So, when a portfolio is structured with specific percentages allocated to specific markets or asset classes such as large U.S. companies or small ones or foreign companies or even emerging market ones, when you have a year such as last year or even this last decade, if you do not rebalance, the allocations you determined were appropriate for the level of expected risk and return the portfolio’s allocation will become skewed, which raises it’s level of risk above what was anticipated and ultimately has been shown to impact returns negatively over the long-term in comparison.
If you do not believe this is significant then you only have to look back to the 2000 – 2002 bear market correction of the 90’s tech and dot.com era, which to this day many have not recovered from or 2008 – 2009’s bear market.
Both events found non-diversified and/or non-rebalanced portfolios maximally exposed at the worst possible time with risk far exceeding even the investors’ most optimistic assumptions with many paying a very dear price for the lack of diversification and discipline having been applied to their portfolios.
The late Nobel Laureate, Merton Miller advised and wrote publicly on many occasions that “diversification is your buddy.” And it is if one follows the dictates of that other Nobel Laureate, Harry Markowitz and his “Modern Portfolio Theory” which tells us that having a rebalanced, non-correlated, diversified portfolio can be expected to provide higher expected rates of return with lower expected risk — over the long-term.
Diversified doesn’t mean having a lot of “stuff in only one asset class (i.e. lots of large U.S. stocks) but rather including various others, including international — where around (per Vanguard) 45% of all global stocks reside. Others estimate when emerging markets, frontier markets and others are included the total reaches upwards of 2/3’s. Thus, if you do not have any international exposure you’re missing out on a substantial portion of the equity universe and it’s potential.
It is somewhat difficult to give any credence to the idea of investing anywhere other than where the Apples, Amazons and Microsofts reside when one focuses only on recent returns.
It continues to be prudent to own equities…globally diversify…rebalance.