Is Diversification Dead?

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Our responsibility as wealth managers is to hold true to a specific set of principles. The most successful long term investors understand that the emotions of fear and greed move markets in shorter time frames but that fundamentals rule over time. They know it’s often better to buy an asset that’s been beaten up and they have the courage to look foolish in the short term. They also understand that, while not always a glamorous strategy, portfolio diversification is essential to long term investing success.

Innumerable studies show diversification works because it allows for better return with less volatility over time. The most important words in the previous sentence are over time. Many people are impatient or distracted by the latest “breaking news” on CNBC. They lose focus and seldom stick to their original, disciplined plan.

A diversified portfolio will always have some contrarian elements. Not every asset class will always have a positive annual return. You’ll always have some laggards alongside the asset classes that are performing well in that particular year.

It’s also important not to assume last year’s top performer will have a repeat performance. This can occasionally happen but if you look at the last 15 years, if you had chosen last year’s hottest asset class and invested in it the following year, you would have had a sub 3% return on average with a great deal more volatility. Chasing returns clearly doesn’t work, and it can be very dangerous.

Where does this put us as we look into 2015?

For starters, we are a little nervous about recency bias – the mistake of assuming the most recent set of outcomes will continue to be the future outcome.

Succumbing to recency bias would push even more money into the S&P 500 index which stood nearly alone as a strong stock market last year. Is it perhaps time to abandon the time-honored, unfashionable faith in diversification? We ask ourselves why shouldn’t we just buy US large cap stocks and sell everything else.

The temptation to continue buying only US stocks is particularly alluring this time around. The S&P has been so strong, and the rest of the world has been so weak. It has meant that any money that has been invested virtually anywhere other than the S&P has been a substantial drag on performance.

As a quick example we can look at 2 well known ETFs:

The SPY (SPDR S&P 500 ETF) returned over 13% in 2014, while the EFA (iShares MSCI EAFE ETF), which is composed primarily of major equities in the rest of the world ex-US, was down 6.2% in 2014. That’s a nearly 20 percentage point differential.

Since the US comprises only about 1/3 of the world’s equity market capitalization, this means that a globally diversified portfolio had a real challenge last year. But there’s also an often unseen reason for optimism here. Two-thirds of the world’s equity market capitalization had a lousy year, and that leads to opportunities.

We made the point that having some of your portfolio positioned in places that might make others think you’re a little silly, or just plain stupid is a key element to being diversified and succeeding as a long term investor. We think there’s truth to the notion that if you wait for all the news to be good, you’re likely paying too high a price.

There also need to be guardrails in place.

A disciplined investor doesn’t just look at cheap asset prices. There needs to be fundamental reasoning behind any investment and there also needs to be limits on how much of your portfolio is allocated to these out-of-favor ideas. Things can’t be bought solely because they are perceived as cheap or because we think they’ve fallen so far they can’t fall much more. Holding onto investments because the crowd still hates them doesn’t necessarily mean they’re on the verge of a turnaround.

After all, sometimes the crowd is right. Investment trends can often last longer than expected. In some cases this behavior can create asset bubbles and we all know how those end.

In recent years, the crowd has come to the US stock market. Our country’s economic recovery has been slow and steady. Likewise, our country’s stock markets have been the global leaders. In our view, while it has led to such strong recent out-performance, the crowd has not yet caused a bubble here domestically. It has, however, created better relative value elsewhere.

Consider the following from a GMO December 2014 research slide:


We think it’s likely that the longstanding trend of the US equity markets leading the developed world may be coming to an end and see it more as a healthy rotation than anything problematic. What is truly impossible to know is whether this trend of US equity market leadership goes even further before giving way.

It might just be that the new leadership is found in the most contrarian of places – Europe.

We wouldn’t suggest anyone gamble the lion’s share of their portfolio on a European recovery, but it needs to be represented in a portfolio as a legitimate possibility, nevertheless.

Consider this view, from Henderson Investments research:

Currently, European markets are trading on a Shiller P/E of 14.4 (MSCI Europe Index) compared to the US which is trading on a Shiller PE of 23.6 (MSCI USA index) or 26.2 is using the S&P 500 Index.

Based on this data the European equity market looks to offer more value than its US counterpart and we can use this data to help formulate forecasts for equity markets. Using the historical data available we were able to construct an analysis of equity market returns based on Shiller P/E data.

The data below suggests there is a correlation between Shiller P/E ratios and long-term equity market returns. More specifically, it illustrates the average annual 5-year forward return for a given Shiller P/E range. For example, investors who invested in European equities with a Shiller P/E between 10 and 15 saw an average annual return of 19.6% over the next 5 years. Similarly, an investor who invested in US equities with a Shiller P/E above 25 experienced an average return of 1.5% over the next 5 years.

Entry Point                  5 Year Average Annual Return

Shiller P/E                   US                    Europe

<10                             17.9%               22.1%

10-15                          15.3%               19.6%

15-20                          16.3%               12.7%

20-25                          8.5%                 1.7%

>25                             1.5%                  3.0%

Currently European equities are trading on a Shiller P/E of 14.4 and we believe this may be an attractive entry point for investors.

An additional point to remember is that investments tend to perform their best as conditions turn from bad to less bad; not from good to great. This scale certainly favors places outside the US.

Here at home we’ve had our unemployment rate drop considerably and we’ve also seen our consumer sentiment improve significantly. This isn’t the nature of things overseas yet.

We’ve also seen our central bank complete a massive Quantitative Easing program. Overseas we are seeing central banks all around the world revving up their engines rather than winding them down.

Then there’s good old fashioned valuation. Henderson chose to focus their research on the Shiller P/E, which is just one metric. Others have focused on different P/E calculations as well as other ratios like price-to-book and dividend discount models. All have come to the same conclusion – that things in the US markets are more expensive than those abroad.

The “Great One”, NHL Hall of Famer Wayne Gretzky, famously said that “a good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.”

The puck, so to speak, has been in the United States. We believe it is going to be overseas in the years ahead.

Gretzky also summoned the spirit of Yogi Berra by saying “you miss 100% of the shots you don’t take.” We think that if investors aren’t taking some shots at the foreign markets, they are going to end up behind rather than ahead over time.

We do not see diversification as the holy grail of investing – no such thing obviously exists. However, diversification can help ease the ups and downs and force you to hold uncomfortable investments in asset classes most investors are too afraid to buy.

We maintain the simple belief that for those investors who do the disciplined things long enough – things like making regular investments, separating their savings from their investment capital and maintaining a diversified approach – the odds of successfully compounding their investments over time are exceptional.


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Investing in securities underlying in currencies other than the U.S. dollar involves certain considerations comprising both risk and opportunity not typically associated with investing in U.S. securities. The security may be affected either favorably or unfavorably by fluctuation in the relative rates of exchange between currencies, by exchange control regulations, or by indigenous economic and political developments. As with any investment, there is no guarantee against potential loss. Investments in securities and insurance products are:
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