Does Diversification Still Work?

Nathan Geraci is President of The ETF Store, Inc. and host of the weekly radio show The ETF Store Show.

With the S&P 500 index up over 27% year-to-date and smaller cap stocks logging even larger gains, 2013 has been one of the more exciting years on record for investors in US stocks.  However, investors holding broadly diversified portfolios might feel like they’ve missed out on the party of the decade.  While US stocks have surged ahead, other asset classes have had less than stellar and, in some cases, downright awful years.  Consider that a popular measure of broad-based US bonds, the Barclays Aggregate Bond Index, is negative for the year.  Other bond categories such as TIPS and emerging market debt are down approaching double digits.  Commodities have also taken it on the chin in 2013 and gold, after an impressive bull run over the past decade, has losses approaching 30%.  Even real estate has labored to squeak out a positive gain.


Since many investors hold diversified portfolios containing a global mix of stocks and bonds, and perhaps alternative investments such as real estate or commodities, it’s likely they’re lagging (perhaps significantly) the S&P 500 Index.  But is this reason for concern?

The concept of diversification is simple.  By holding a combination of investments that perform differently in changing market conditions, investors can potentially lower the overall volatility (or risk) of their portfolios without sacrificing long-term returns.  The specific mix of investments will vary from investor-to-investor based on factors such as risk tolerance, time horizon, and required rate of return, but the idea is still the same – don’t put all of your eggs into one basket.  While US stocks are flying high right now, think back to 2008 when the S&P 500 was down around 37%.  That same year, gold (IAU) was up approximately 5% and longer-term US treasury bonds (TLT) were up almost 34%!  Investors holding positions in these asset classes were clearly thankful their portfolio wasn’t loaded up entirely on US stocks.  That’s the value of diversification.

While 2008 may be an extreme example, consider the performance of some of the major asset classes over the past twenty years.  As it turns out, a 2013 laggard – emerging market stocks, was the top performer in nine of those twenty years.  Aggregate bonds were the top performer in three of the years, with developed international stocks outperforming in one year and US stocks the outperformer in the other seven.  Note this doesn’t include gold or other commodities, the former of which has quintupled since 2000. The point is simply that different asset classes will likely take turns as the outperformer in any given year or years.

All of which brings us back to whether investors in diversified portfolios should have cause for concern right now.  For much of the past year, diversification simply hasn’t “worked” in the sense that investors have been “penalized” for holding assets classes other than US stocks.  But this is the exact moment where it’s critically important to keep longer-term investing goals in mind.  US stocks could certainly outperform again next year, but unless you own a crystal ball, you have to ask yourself if that’s a bet you’re willing to make in your portfolio.  For investors or professional money managers who believe they have the ability to make that bet, I would encourage you to review the data on the likelihood of success – it isn’t pretty.

As we close out 2013, my advice to investors is simple.  Don’t become enamored with year-end headlines touting the run-up in US stocks and lose sight of the bigger picture.  Without a doubt, US stocks are on quite a roll and should certainly be a core holding in most investor portfolios.  However, such a remarkable run can quickly cause investors to forget about the dot-com crash in 2000 or the financial crisis in 2008.  If history is any guide, it’s typically right around the time when investors become complacent and throw caution to the wind, that the benefits of diversification force their way back to center stage.  Quite frankly, diversified investing can be boring and it’s certainly not as exciting as chasing the next hot investment or asset class, but the longer-term rewards can be greater and the ride much smoother.  Some have even called diversification the only free lunch in investing (I might argue another free lunch is lower investment fees).  Regardless, diversification still works – it’s just waiting for you to forget about it.