Keep
Calm
and
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Diversified

A Short- and Long-term
Review of the Power of Diversification

For generations, investors have looked to stock exchanges as a way to participate in the growth of both local and far-reaching economies, drawn by the hope of earning a healthy return on their investment.

In the U.S., stocks have fueled the growth of our nation’s wealth since the early 1800s. While past performance is never a guarantee of future results, it is easy to see why the stock market has captured the attention of so many over the years. As the chart below shows, an investment of $10,000 in the S&P 500 in 1926 would have grown to more than $73 million by 2017. That kind of growth makes many ask, “Why not invest all my savings in stocks?"

S&P 500 Index total return through market cycles since 1926

Source: FactSet, S&P Dow Jones Indices. The index is unmanaged, is not available for investment and does not incur expenses.
Past performance is no guarantee of future results.

The Problem of Volatility

Stock Market Returns Are Seldom Average

The fact is, stock prices are volatile, moving up or down in ways that are often unpredictable. The chart below shows an annual growth rate of 10.2% for the S&P 500 Index since 1926. Yet in terms of actual annual performance, the Index has only come close to 10% six times in that period; in every other year, returns have either been well above or below the average.

What makes the stock market so unpredictable? Share prices are influenced by a range of factors including company performance, shifting industry dynamics, and changes in the economic or geopolitical landscape. These changes can happen quickly, and sometimes have a dramatic impact on stock prices. For this reason, anyone interested in the stock market needs a plan for dealing with the risk of volatility.

Source: FactSet, S&P Dow Jones Indices. Data calculated from 1926-2017 using total return.
Past performance is no guarantee of future results.

 

 

Why Your Time Horizon Matters

To answer the question, “Why not invest all my savings in stocks?” it helps to take a closer look at the impact volatility can have on a short-term strategy.

The chart below shows annual returns of the S&P 500 over the past 20 years. If you had invested over the full 20 years, you would have come out ahead, even though you would have gone through two recessions (in 2001 and 2008). Investors with shorter time horizons may have also fared well if they happened to buy at just the right time (e.g., 2003 or 2009). But if they got the timing wrong, the effect of volatility could have been devastating to their portfolio.

Even in a positive year like 2009, someone who was invested for the full year would have earned 26.5%, but an investor who sold at the wrong time during that same year could have experienced a crushing -27.2% return.

It’s easy to see how a speculative approach to investing—sometimes called “chasing returns” or “timing the market”—can be an unwise course. The fact is, the longer your time horizon, the more risk you can handle because your investment will have more time to recover in the event of a market downturn.

S&P 500 intra-year declines vs. calendar year total returns (1998-2017)

Source: FactSet, S&P Dow Jones Indices. The index is unmanaged, is not available for investment and does not incur expenses. Data calculated from 1998-2017 using total return.
Past performance is no guarantee of future results.

 

 

2017 Was the Exception, Not the Rule

If you held U.S. large cap stocks or mutual funds in 2017, you were fortunate to have experienced the first time in 90 years in which the S&P 500 generated 12 consecutive months of positive returns. But that kind of performance is not normal. Near-term markets have already shown that, in most years, there will be ups and downs in the market.

Number of positive months by calendar year

Source: FactSet, S&P Dow Jones Indices.

Diversification: A Time-Tested Strategy

Throughout history, investors have used diversification to reduce the volatility of their portfolios. The age-old adage “Don’t put all your eggs in one basket” describes this approach. Picture the feudal lord reducing risk by planting five different crops instead of just one. Today, by investing across a number of categories that respond to market changes differently, you can eliminate some of a portfolio’s volatility.

Combining Asset Classes for Lower Risk

One way to visualize this concept is by looking at individual asset class performance over time (see chart below). Taking a step back from this chart can help give an understanding of its big-picture message:

The different categories or asset classes that comprise the stock market experience vastly different performance year to year. By combining these asset classes into one diversified portfolio, however, returns can be “smoothed out” over time.

The diversified portfolio has never been at the top of the performance chart, but it has never been at the bottom, either. This is because weaker categories are balanced by stronger ones. Keep in mind that diversification will not protect against negative returns in market downturns in which all asset classes decline in value.

A Review of Asset Class Performance Over the Last 20 Years

Source: Barclays, Bloomberg, Dow Jones, FactSet, MSCI Russell, Standard & Poor’s. Past performance is no guarantee of future results.
The indices are unmanaged, are not available for investment and do not incur expenses. The performance shown is not indicative of the performance of any mutual fund or other investment product.

Think beyond the S&P 500 Index

A Diversified Portfolio* has historically smoothed out the ride over the long term without sacrificing returns.

The chart below demonstrates the unpredictable nature of individual asset class returns in a different way. In this chart, U.S. large cap equities are used as the “anchor” asset class. Compared to the anchor, you can see that the performance of other asset classes is erratic; a category that beat U.S. large caps one year can easily underperform in the next year. But when a number of asset classes are combined into one diversified portfolio (the black rectangles), some of that unpredictability is removed.

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 Roll over for a breakdown of the diversified portfolio

Source: FactSet. As of December 31, 2017. Click here for a list of representative indices. Past performance is no guarantee of future results.

Diversification does not guarantee a profit or protect against a loss in declining markets.
The indices are unmanaged, are not available for investment and do not incur expenses.
The performance shown is not indicative of the performance of any mutual fund or other investment product.

The chart below illustrates this concept differently. The high and low marks for each year (the circles) show the span between the top-performing and bottom-performing asset classes. The wider the span, the more variability between the performance of the asset classes. By contrast, the black squares show how a diversified portfolio that includes all of the asset classes would have fared. By investing across all categories, an investor would have experienced less volatility.

It’s challenging to predict the top performing asset class every year

Source: FactSet, as of December 31, 2017. Past performance is no guarantee of future results. The diversified portfolio is rebalanced to the original allocation annually. The indices are unmanaged, are not available for investment and do not incur expenses.

Less Risk, Similar Returns

With any kind of investing, there is a tradeoff between risk and return: Investments offering the greatest potential for returns come with the highest degree of risk, and low-risk investments typically produce lower returns. The added advantage of a sound diversification strategy is that it can potentially eliminate some of the portfolio risk for which the investor is not compensated. In other words, if you don’t diversify, you take on risk that does not necessarily add to your potential returns.

The chart below compares a diversified portfolio with an investment in the S&P 500 over the last 20 years. At the end of the period, both investments generated similar returns. The Index, however, experienced greater volatility (and therefore more risk) than the diversified portfolio.

Diversified Portfolio and S&P 500 Index Returns

Source: Barclays, FactSet, Standard & Poor’s. Past performance is no guarantee of future results. Bear Market defined as peak-to-trough decline of at least 20 percent.

The chart below sums up this concept. Both the S&P 500 and the diversified portfolio generated returns of around 7.2%, yet the standard deviation (a measure of risk) shows less risk in the diversified portfolio. This helps prove that diversification can reduce some of a portfolio’s risk without sacrificing returns.

20-year returns and standard deviation (1998-2017)

Source: FactSet, S&P Dow Jones Indices. See back cover for representative indices. Past performance is no guarantee of future results. Standard Deviation (Std. Dev.): A measure of risk; it calculates the variability of returns by comparing the Fund’s return in each period with the average Fund return across all periods.

Action Plan

The recent increase in stock market turbulence underscores the importance of having a sound diversification strategy in place. The benefits of diversification are clear in terms of providing:

  • Less risk than a non-diversified portfolio
  • A smoother ride through market ups and downs
  • A better sense of preparedness in the event of a market downturn

Your financial advisor can offer guidance to help ensure your portfolio is diversified appropriately. He or she may:

  • Assign different risk levels to parts of your portfolio that are linked to specific goals such as:
    • Saving for college
    • Planning for retirement
    • Other short- and long-term personal goals
  • Where applicable, develop a strategy to reduce concentration risk associated with employee stock options
  • Monitor your diversification strategy annually, rebalancing as needed to avoid unintended concentrations in any one category



The diversified portfolio is based on a 5% allocation to cash, 25% allocation to investment grade bonds, 5% allocation to municipal bonds, 20% allocation to S&P 500 Index, 10% allocation to small caps, 5% allocation to commodities, 15% allocation to international equities, 5% allocation to emerging markets, 5% allocation to REITs, and a 5% allocation to alternatives.

Investments in debt securities are subject to credit and interest rate risk. An increase in interest rates typically causes the value of bonds and other fixed income securities to fall.

Investments in international securities are subject to certain risks of overseas investing including currency fluctuations and changes in political and economic conditions, which could result in significant market fluctuations. These risks are magnified in emerging markets.

Investments in small-capitalization companies are subject to greater price volatility, lower trading volume and less liquidity than investing in larger, more established companies.

Real estate investments are subject to factors such as changing general and local economic, financial, competitive and environmental conditions.

Alternative investments are speculative, subject to high return volatility and involve a high degree of risk including, but not limited to, the risks associated with leverage, derivative instruments such as options and futures, distressed securities, may be illiquid on a long term basis and short sales. There can be no assurance that these types of strategies will achieve their objectives or avoid substantial losses. Alternative investments may also be subject to significant fees and expenses.

The Bloomberg Barclays U.S. Corporate High Yield Bond Index (Representing U.S. High Yield) is a total return performance benchmark for fixed income securities having a maximum quality rating of Ba1 (as determined by Moody’s Investors Service).

Bloomberg Barclays U.S. Aggregate Bond Index (Representing Investment Grade Bonds): The Bloomberg Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.

The Bloomberg Barclays U.S. Municipal Bond Index (representing U.S. Muni Bonds) is a broad-based benchmark that measures the investment grade, U.S. Dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured, and pre-refunded bonds.

The HFRI Fund Weighted Composite Index (Representing Alternatives): is a global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in U.S. Dollar and have a minimum of $50 Million under management or a twelve (12) month track record of active performance. The HFRI Fund Weighted Composite Index does not include Funds of Hedge Funds.

MSCI World Index Ex USA (Representing International Equity): The MSCI World ex USA Index captures large and mid cap representation across 22 of 23 developed markets countries*—excluding the United States. With 1,021 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

MSCI Emerging Markets Index (Representing Emerging Market Equity): The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 24 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates.

The MSCI All Country World Index (ACWI) ex USA Small Cap (representing International Small Cap) captures small cap representation across 22 of 23 Developed Markets (DM) countries (excluding the U.S.) and 24 Emerging Markets (EM) countries*. With 4,329 constituents, the index covers approximately 14% of the global equity opportunity set outside the U.S.

Russell 2000® Index (Representing U.S. Small Cap Equity) Measures the performance of approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States.

The Dow Jones U.S. Select REIT Index (representing U.S. Real Estate) tracks the performance of publicly traded REITs and REIT-like securities and is designed to serve as a proxy for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.

The S&P 500 Index (Representing U.S. Large Cap Equity) is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The indices are unmanaged, are not available for investment and do not incur expenses.

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