BACK TO THE BOUTIQUE INVESTOR BLOG S&P 500 for Show, Diversification for Dough* Thomas S. Moles VICE PRESIDENT | HEAD OF MARKETING Diversification is one of the basic rules of investing and is also a critical way advisors add value to client accounts. Yet over the last decade, and particularly over the last year, many clients have lost faith in diversification as a risk management strategy. The main reason is the dominance of U.S. large cap stocks in the most recent 11-year bull market. The fact is, from 2009 through 2019, investors with diversified portfolios underperformed those who simply invested in the S&P 500® Index. So if the S&P 500 can beat the broader market, why bother to invest anywhere else? A cognitive bias called herding only magnifies this effect: Every mention of the S&P 500 in conversations with friends and colleagues, as well as in the media, makes clients that much more eager to jump on the bandwagon. Is Diversification as a Risk Management Strategy Dead? The chart below gives advisors an easy way to talk to clients about the importance of keeping equity investments diversified. The main message is that it’s impossible to consistently pick the market’s best performing sectors year after year. Choose any color on the chart and you can see that today’s winning sector can easily become next year’s loser. Given that markets remain uncertain, diversification is still one of the best options for managing risk. A Review of Asset Class Performance Over the Last 24+ Years1995199619971998199920002001200220032004200520062007200820092010201120122013201420152016201720182019YTD 2020falseUS LC37.6%falseUS SC28.5%falseAlts21.5%falseDiv Port20.3%falseUS HYB19.2%falseIG Bond18.5%falseMunis17.5%falseREITs12.2%falseFor Dev11.4%falseIntl SC0.2%falseEM-5.2%falseREITs37.1%falseUS LC23.0%falseAlts21.1%falseUS SC16.5%falseDiv Port12.1%falseUS HYB11.4%falseFor Dev6.9%falseEM6.0%falseMunis4.4%falseIG Bond3.6%falseIntl SC2.2%falseUS LC33.4%falseUS SC22.4%falseREITs19.7%falseAlts13.4%falseDiv Port13.4%falseUS HYB12.8%falseIG Bond9.7%falseMunis9.2%falseFor Dev2.3%falseEM-11.6%falseIntl SC-18.7%falseUS LC28.6%falseFor Dev18.8%falseIG Bond8.7%falseDiv Port8.6%falseMunis6.5%falseIntl SC5.0%falseAlts2.6%falseUS HYB1.9%falseUS SC-2.6%falseREITs-17.0%falseEM-25.3%falseEM66.4%falseIntl SC32.7%falseAlts31.3%falseFor Dev27.9%falseUS SC21.3%falseUS LC21.0%falseDiv Port15.3%falseUS HYB2.4%falseIG Bond-0.8%falseMunis-2.1%falseREITs-2.6%falseREITs31.0%falseMunis11.7%falseIG Bond11.6%falseAlts5.0%falseDiv Port-0.3%falseUS SC-3.0%falseUS HYB-5.9%falseUS LC-9.1%falseFor Dev-13.4%falseIntl SC-18.1%falseEM-30.6%falseREITs12.4%falseIG Bond8.4%falseUS HYB5.3%falseMunis5.1%falseAlts4.6%falseUS SC2.5%falseDiv Port-1.2%falseEM-2.6%falseUS LC-11.9%falseIntl SC-14.6%falseFor Dev-21.4%falseIG Bond10.3%falseMunis9.6%falseREITs3.6%falseUS HYB-1.4%falseAlts-1.5%falseDiv Port-5.1%falseIntl SC-5.7%falseEM-6.2%falseFor Dev-15.8%falseUS SC-20.5%falseUS LC-22.1%falseIntl SC57.6%falseEM55.8%falseUS SC47.3%falseFor Dev39.4%falseREITs36.2%falseUS HYB29.0%falseUS LC28.7%falseDiv Port25.8%falseAlts19.6%falseMunis5.3%falseIG Bond4.1%falseREITs33.2%falseIntl SC29.3%falseEM25.6%falseFor Dev20.4%falseUS SC18.3%falseDiv Port13.0%falseUS HYB11.1%falseUS LC10.9%falseAlts9.0%falseMunis4.5%falseIG Bond4.3%falseEM34.0%falseIntl SC22.6%falseFor Dev14.5%falseREITs13.8%falseAlts9.3%falseDiv Port7.9%falseUS LC4.9%falseUS SC4.6%falseMunis3.5%falseUS HYB2.7%falseIG Bond2.4%falseREITs36.0%falseEM32.1%falseIntl SC26.9%falseFor Dev25.7%falseUS SC18.4%falseUS LC15.8%falseDiv Port15.1%falseAlts12.9%falseUS HYB11.9%falseMunis4.8%falseIG Bond4.3%falseEM39.4%falseFor Dev12.4%falseIntl SC10.8%falseAlts10.0%falseIG Bond7.0%falseDiv Port6.7%falseUS LC5.5%falseMunis3.4%falseUS HYB1.9%falseUS SC-1.6%falseREITs-17.6%falseIG Bond5.2%falseMunis-2.5%falseAlts-19.0%falseDiv Port-23.1%falseUS HYB-26.2%falseUS SC-33.8%falseUS LC-37.0%falseREITs-39.2%falseFor Dev-43.6%falseIntl SC-50.2%falseEM-53.3%falseEM78.5%falseIntl SC62.9%falseUS HYB58.2%falseFor Dev33.7%falseREITs28.5%falseUS SC27.2%falseUS LC26.5%falseDiv Port26.2%falseAlts20.0%falseMunis12.9%falseIG Bond5.9%falseREITs28.1%falseUS SC26.9%falseIntl SC25.2%falseEM18.9%falseUS HYB15.1%falseUS LC15.1%falseDiv Port13.6%falseAlts10.3%falseFor Dev9.0%falseIG Bond6.5%falseMunis2.4%falseMunis10.7%falseREITs9.4%falseIG Bond7.8%falseUS HYB5.0%falseUS LC2.1%falseDiv Port0.3%falseUS SC-4.2%falseAlts-5.3%falseFor Dev-12.2%falseEM-18.4%falseIntl SC-18.5%falseIntl SC18.5%falseEM18.2%falseREITs17.1%falseUS SC16.4%falseFor Dev16.4%falseUS LC16.0%falseUS HYB15.8%falseDiv Port11.9%falseMunis6.8%falseAlts6.4%falseIG Bond4.2%falseUS SC38.8%falseUS LC32.4%falseFor Dev21.0%falseIntl SC19.7%falseDiv Port13.5%falseAlts9.1%falseUS HYB7.4%falseREITs1.2%falseIG Bond-2.0%falseEM-2.6%falseMunis-2.6%falseREITs32.0%falseUS LC13.7%falseMunis9.1%falseDiv Port6.6%falseIG Bond6.0%falseUS SC4.9%falseAlts3.0%falseUS HYB2.5%falseEM-2.2%falseIntl SC-4.0%falseFor Dev-4.3%falseREITs4.5%falseMunis3.3%falseIntl SC2.6%falseUS LC1.4%falseIG Bond0.6%falseDiv Port-0.8%falseAlts-1.1%falseFor Dev-3.0%falseUS SC-4.4%falseUS HYB-4.5%falseEM-14.9%falseUS SC21.3%falseUS HYB17.1%falseUS LC12.0%falseEM11.2%falseDiv Port7.8%falseREITs6.7%falseAlts5.4%falseIntl SC3.9%falseFor Dev2.8%falseIG Bond2.7%falseMunis0.3%falseEM37.3%falseIntl SC31.7%falseFor Dev24.2%falseUS LC21.8%falseUS SC14.7%falseDiv Port14.0%falseAlts8.7%falseUS HYB7.5%falseMunis5.5%falseREITs3.8%falseIG Bond3.5%falseMunis1.3%falseIG Bond0.0%falseUS HYB-2.1%falseREITs-4.2%falseUS LC-4.4%falseAlts-4.5%falseDiv Port-5.5%falseUS SC-11.0%falseFor Dev-14.1%falseEM-14.6%falseIntl SC-18.2%falseUS LC31.5%falseUS SC25.5%falseREITs23.1%falseFor Dev22.5%falseIntl SC22.4%falseDiv Port18.5%falseEM18.4%falseUS HYB14.3%falseAlts10.4%falseIG Bond8.7%falseMunis7.5%falseIG Bond6.1%falseMunis2.1%falseUS LC -3.1% falseAlts-3.5%falseDiv Port -3.7%falseUS HYB-3.8% falseEM -9.8% falseFor Dev -11.5%falseIntl SC-12.8%falseUS SC-13.0%falseREITs -22.0%Source: Barclays, Bloomberg, Dow Jones, FactSet, MSCI Russell, Standard & Poor’s as of June 30, 2020. The indices are unmanaged, are not available for investment, and do not incur expenses. Click here for index definitions. The diversified portfolio is rebalanced to the original allocation annually. The performance shown is not indicative of the performance of any mutual fund or other investment product. Past performance is no guarantee of future results. In the chart, the dark green squares show the performance of U.S. large caps, represented by the S&P 500 Index. We have added a diversified portfolio** (the black squares) to show how spreading risk across a range of investment categories provides a smoother ride through market cycles. The message for clients is that diversification offers a trade-off: In exchange for giving up the chance of being the market’s top performer, you can avoid being its worst performer. That’s the right trade-off for most clients since investors who stay diversified are more likely to stay invested during volatile times, are less likely to miss the market’s best days, and therefore have a greater chance of achieving their long-term personal financial goals. Remember, the best portfolios aren’t necessarily those with the highest returns, but rather those that clients can stick with in both bull and bear markets. Managing Client Expectations Taking time to educate clients about the importance of diversification will help keep their expectations for future performance rational. By focusing on the middle third of the chart—the range of the diversified portfolio’s performance—clients should be able to gain a sense for the trade-off between risk and reward. This point is well demonstrated in the bear-market years of 2000–2002 and 2007–2008. In each of these cases, the diversified portfolio outperformed U.S. large caps. In the absence of a crystal ball, diversification remains an essential strategy for keeping client portfolios on track. For more ideas for coaching clients through volatile times, visit our resource center below. *Diversification does not guarantee a profit or protect against a loss in declining markets. **Diversified Portfolio Allocation: Investment Grade Bonds (IG Bonds): 30%, Municipals (Munis): 5%, U.S. High Yield Bonds (US HYB): 5%, U.S. Large Cap Equity: (US LC): 20%, U.S. Small Cap Equity (US SC): 10%, Foreign Developed Equity (For Dev): 10%, International Small Cap (Intl SC): 5%, Emerging Markets (EM): 5%, U.S. Real Estate (REITs): 5%, and Alternatives (Alts): 5%.