Are you part of the walking dead? Did you make that mistake this year and hold a diversified portfolio? Before you go running to the “All You Can Eat S&P” buffet, take two minutes and read about it.
Asset allocation is the process of diversifying your portfolio by investing in different asset categories like Large Cap Equity, Small Cap Equity, International Equity, Core Fixed Income and High Yield Bonds. This strategy is used because each asset class has different return and risk characteristics. Most importantly, some asset classes may perform well in one market while others lag. How these asset classes react to one another is called correlation.
Studies Prove that Asset Allocation beats Stock Picking and Market Timing
In 1986, a ten year study of 91 pension plans showed that asset allocation dominated security selection and market timing, explaining 93.6% of variation in a plans’ return. (Beebower, Brinson, Hood “Determinants of Portfolio Performance”). The study was conducted again in 1991 and confirmed that asset allocation was superior.
Why Diversification Hasn’t Worked in 2013?
If diversification has proven successful overtime, why are we questioning it today? Simply, diversification works over time, not every time.
Why has 2013 been a very difficult year for diversification?
•Domestic stocks are exhibiting strong positive performance
•Fixed Income is in a challenging environment, with rates being at an all-time low and speculated to rise
•Commodities and inflation related assets are performing poorly, because inflation does not seem to be on the horizon
In short, one asset class is driving the market. Concentrated portfolios can and often do outperform their diversified counterparts.
The chart below plots the year-to-date performance of a number of asset classes versus the S&P 500 as of September 30, 2013. It shows why diversification hasn’t been popular this year.
Why Not Just Buy the Asset Class that will Outperform?
Market timing is difficult, if not impossible, to execute successfully. Look at the chart showing asset class returns for the last 10 years. As you can see, it is anybody’s guess to what asset class will lead the pack in any given year. This reinforces why diversification is so important.
Everybody hates bonds today, so let’s pick on the worst performing asset class this year relative to the S&P 500, Long-Term U.S Treasuries.
Below is a chart of the S&P 500 vs Long Term Treasuries for the last 11 months.
Based on the last 11 months, who would want to be in Treasuries? Looks like a sucker’s bet.
But..many retail investors have forgotten what happened in 2007?
Remember we diversify to reduce risk, because you don’t want all your eggs in one basket. Or do you? Treasuries returned 12.6% annually over that period while the S&P 500 went down -37% and took several years to recover. Asset allocation wasn’t the walking dead back then.
Certainly, this year has been one of those times where we are compelled to abandon diversification and jump on the S&P 500 train, but doing so carries significant risk. Investment success is all about finding the best opportunities, blending them to create efficient portfolios and remaining invested long term. Holding an attractive long-term portfolio, however, is not always easy over shorter time frames.
Staying vigilant with a well-rounded asset allocation strategy has proven its worth over time. Unless you believe that this time is different.