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Q3 2017
Diversification: It's Not Always Easy To Do The Right Thing

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In a world where the latest record high on the Dow Jones Industrial Average or the S&P 500 Index dominates financial headlines, the traditional well-diversified investment portfolio has fallen out of favor. Diversification is a time-tested method of portfolio construction that reduces risk (standard deviation) and delivers more consistent returns, but what it doesn’t do is make headlines by delivering attention-grabbing performance. Accordingly, investors are often disappointed when they compare the results of a diversified portfolio with the results of a single index.
Everybody loves a winner In a world where the latest record high on the Dow Jones Industrial Average or the S&P 500 Index dominates financial headlines, the traditional well-diversified investment portfolio has fallen out of favor. Diversification is a time-tested method of portfolio construction that reduces risk (standard deviation) and delivers more consistent returns, but what it doesn’t do is make headlines by delivering attention-grabbing performance. Accordingly, investors are often disappointed when they compare the results of a diversified portfolio with the results of a single index.

Diversification rarely wins in any given year…

As a result, many investors want to buy last year’s winner; in the short-term, this strategy sometimes works well. Over the past 10 years, a trend-following strategy—one that invests in the top-performing asset class from the prior year—would have been the top performer 40% of the time. Similarly, a contrarian strategy—one that invests in the worst-performing asset class from the prior year—would also have been the top performer 40% of the time. A diversified strategy that invested equally in each asset class would have been the top performer only 20% of the time.
 

…But diversification also rarely loses

Looking solely at how often each strategy outperforms tells only part of the story. If we look at the number of times each strategy was the bottom performer, we observe that both the trend-following and contrarian styles finished worst 40% of the time.

The diversified portfolio finished last in just two out of 10 years, returning 10.0% in 2007 and 8.4% in 2016—robust gains that are above the long-term expected and historical average returns for a diversified strategy.
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The proof

While the trend-following and contrarian strategies often have the best opportunity to outperform, they also have the highest tendency to underperform. The diversified strategy may not offer the same opportunity for short-term gains, but the relative stability helps to avoid significant losses in a given year. Over longer, multi-year periods, a strategy that successfully avoids significant losses will tend to outperform, and experience less volatility. This is the reason responsible financial advisors recommend diversification as the right thing to do for their clients.

If we examine the 10-year period as a whole, we observe that the contrarian strategy actually lost value despite being the top performer in four separate years. This resulted in an average loss of 0.1% per year and came with stunningly high volatility of 31.2% annually. The trend-following strategy performed even worse, losing 1.1% annually; although volatility was a bit better at 23.3%. The diversified strategy outpaced both with an average gain of 4.1% and only 12.4% volatility. It’s quite clear that the strategy with the most consistent returns comes out on top in the long term.


It’s not always easy to do the right thing

Over the past decade, prudent financial advisors have had to defend performance of well-diversified portfolios in eight out of 10 annual client meetings. While this task may seem daunting, just imagine having to defend a trend-following emerging-market equities portfolio after it plummeted by 53.3% in 2008. The contrarian strategy presented similar challenges following consecutive losses of -9.5%, -17.0% and -24.7%, respectively, from 2013 – 2015, in a portfolio concentrated in commodities.

 

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