Markets once again demonstrate the power of diversification

Portfolio allocation across a range of companies, countries, and asset classes plays a dual role in investing. Firstly, it protects you from risk: if one of these titles unexpectedly goes down, you won't lose a significant portion of your invested wealth. Secondly, it guarantees that you will capture growth wherever it occurs in the market, as it is difficult to predict in advance which market segments will grow.

It sounds nice in theory, but over time the will of every investor gets tested. Some sectors or asset classes can maintain above-average returns for years, with the rest of the portfolio acting as a poor complement. Others can experience significant falls or stagnation, after which many investors prefer to avoid them. And in times of uncertainty, the temptation to look for individual stocks that will be lucky in the near term, rather than holding the whole market, also rises.

So should we occasionally try to reduce diversification based on past experience? In this article, we will try to find the answer using both recent market experience and historical data.

The Temptation to Look Over One's Shoulder

Over the past decade, a superstar named the U.S. stock market has featured in the investment world. The S&P 500 index of large U.S. companies has earned an average return in excess of 10% per year over the 10-year period ending December 2022. European equities delivered half that return on an annualized basis over the period.

Note: The chart records the price returns resulting from changes in the prices of the stocks in the index. Thus, it does not include gains from distribution payments to shareholders (e.g. dividends). The total return from holding the indices was therefore higher over the period.

Many investors are therefore taking longer to consider whether it is worth investing in regions other than the United States at all. If they have a lower long-term return, they represent an unnecessary drag on the portfolio compared to a simple investment in the S&P 500 index. We also occasionally get questions from clients asking if we offer Finax portfolios without European equities.

The temptation to reduce diversification based on recent performance is often encountered. Prior to the start of 2022, we faced strong pressure to increase the proportion of technology stocks, which were then growing like crazy. Many investors are fed up with investing in emerging markets, which haven't returned much over the past decade. In turn, following the recent sell-off in the bond market, we are seeing increased interest in changing strategies to more dynamic ones with lower bond weighting.

Following the onset of market stagnation of the past 1.5 years, there has also been a growing view that diversified investing only works in times of market growth. If the markets are not moving much, such a strategy guarantees months or years of low returns. As an alternative, they suggest concentrated investment in a few titles in the hope that these investments will jump on an uptrend despite the lazy market sentiment. Most of the time, this is how Berkshire Hathaway, Warren Buffett's famous firm, invests.

The Party That Is Coming to an End

It probably won't surprise you to hear us recommend resisting such temptations and maintaining broad diversification. The allocation of your money should at all times be consistent with your long-term investment strategy (i.e., investment duration, risk tolerance, etc.).

For example, if you are not afraid of downturns and plan to invest for decades, you can put all your money in stocks. If you need the money in a few years, you can mitigate the risk by combining stocks and bonds. You should not adjust this allocation to recent experience.

In fact, diversification has two basic advantages:

• Limiting risk: crises hit different regions or asset types with different forces. If one of them is in a sharp decline, the rest can hold you up. This will limit the overall drawdown of your portfolio, making it easier to mentally weather downturns (after all, it's easier to look at a temporary 10% loss than a 30% loss). At the same time, you can flip back into profit more quickly.
• Capturing growth: different regions and assets take the title of growth superstar on a regular rotation. In any given decade, some grow above average and others stall in place. With a widespread, you are assured of having a portion of your money invested in a growth region. In other words, you reduce the chances of having your entire wealth in an investment that isn't going anywhere.

This approach, of course, is not perfect. By holding the entire market, you are necessarily buying the parts that will do less well during a given period. During any given year, you will hear of investors who bought the winning segment and made more than the market. By holding the market you earn the market return, you can only beat it by concentrated investment in specific titles or segments.

These principles were confirmed by a recent study published in The Journal of Portfolio Management. Although its authors acknowledge that U.S. stocks have outperformed the rest of the markets over the past 30 years, they continue to argue for the importance of diversification. Using data, they show that one of its greatest advantages is the greater predictability of long-term returns.

That's because it minimizes the chance that you'll still be in the red after many years of investing if there's a sustained bear market in one of the local markets. So while it will reduce the chance that you will earn an above-average 15% per year over the next 10 years, it will also limit the likelihood that you will earn only 4% per year over that period. And if your goal is to build wealth responsibly, you certainly shouldn't neglect such a risk.

Reducing diversification based on past experience can be a double-edged weapon. The more a particular type of investment has performed in recent years, the more likely it is to be overpriced. This is because many investors buy it just "to be on the safe side" and when they collectively realize that the underlying value (e.g. company profitability) does not match the price at all, years of stagnation may follow.

Investments that have in turn notoriously underperformed are more likely to be sold at too low a price relative to their underlying value. Indeed, investors are reluctant to put money into them in view of their poor past performance. However, if they suddenly realize that it is undervalued, there will be a surge.

So if you move money according to past performance, you risk moving funds from undervalued to overvalued sectors and losing money unnecessarily. In fact, you will arrive at the party at a time when it is already coming to an end. The food and drinks are gone, people are leaving to get home, and the music isn't playing. The juicy returns have already been distributed and the only thing you can join is the morning clean-up.

European Markets Have Woken Up

Recent market developments only confirm the truth of these principles. The S&P 500 Index has been staggering around the same level since last summer, earning roughly 0.5% over the past 12 months (again, note that returns do not include distribution payments).

Conversely, several European indices have produced much sharper recoveries, with the broad Stoxx 600 index being in the black by nearly 6% over the past year, and narrower indices such as the German DAX and the French CAC 40 earning even more (12.1% and 15.2%, respectively). Some of them have recorded all-time highs in recent months.

Who would have said that a year ago? Last summer, it was a region with a long history of unconvincing performance, war raging within its borders, and residents worried about having enough gas to heat their homes in winter. Today, European stocks are dragging up the returns of global investors.

There are several reasons. We found alternative gas suppliers unexpectedly quickly and, with the help of a mild winter, we survived the energy crisis with minimal damage. Corporate profits have shown admirable resilience to inflation and rising interest rates. Close trade relations with China have brought demand for the lifting of anti-pandemic restrictions there.

That's the way it goes in investing. Guaranteed and widely anticipated events do not happen or are fully reflected in share prices and their realization then does not induce a market response. Today, nobody asks us to take European equities out of our portfolios.

And it is possible that Europe will retain its advantage over the next few years. In times of high interest rates, value investments, which are more prevalent in Europe, do better. US indices are dominated by technology growth stocks, whose value is sensitive to rising interest rates.

In addition, investors may be attracted to the old continent by the attractive ratio of share prices to corporate earnings. In the chart below, you can see that in Europe you can buy the same earnings at a significantly lower price.

Source:  Refinitiv Datastream 

This is not to say that European equities will continue to outperform the rest of the world; it may well be the other way around. And certainly not that you should direct the bulk of your investments into European equities. What I meant to illustrate is that the title of the best-performing investment is often claimed by a market segment no sane person would suggest beforehand. That is why you need to invest in a diversified way.

A Recurring Pattern

This example is far from unique, history has shown us many times why we should not limit diversification based on the returns of the last 10 years.

In 2021, for example, technology stocks were a big trend. We have also had a number of requests to increase their weighting in the Intelligent Investing portfolios. Rising interest rates have deflated the sector's valuations, and the US Nasdaq technology index is down 25% so far from its last peak (significantly more than the other indices mentioned).

Bonds may become the opposite story in the next few years. Thanks to rising interest rates, they offer attractive returns. Even the safest government bonds are now yielding 2-4%, you just need to buy them at the current distressed prices and wait patiently for the yield to gradually get paid out. However, we see rather the opposite behavior in people, with bond funds experiencing outflows in favor of equity funds.

The justification for diversification is also shown by historical data. The chart below compares the performance of the US equity markets and the rest of the developed countries represented by the MSCI EAFE Net Total Return Index. This index includes 21 developed markets from the Europe, Pacific, and Asia regions.

You can see in it that the title of the stronger region rotates regularly, and before the current era of US equities began, it was even more common for stocks from other developed countries to outperform.

The same is true for emerging market investing. The chart below compares the cumulative performance of developed and emerging market equity indices.

You can see that despite poor returns over the past decade, emerging markets absolutely dominated the previous two decades. If you had invested in a portfolio composed of both indices in the late 1980s, emerging markets would still be dragging up your average return today (compared to an investment spread only among developed market countries).

This chart also shows the other side of the coin of US equities. In 2010, they had lived through a lost decade, not earning anything since 2000. Many people got burned on stock investments during the 2008 crisis and avoided the Wall Street stock exchange like the devil for many years to come.

Today, you know that this formerly damned investment has been such a success over the next decade that many investors today do not want to hold anything else. So don't just buy the past winners; damned investments may well become the next winners.

What this Article Wasn't Trying to Say

In conclusion, be warned to interpret the examples from this blog cautiously. For example, I was not trying to say that US stocks are a bad investment with this article. Over the long term, it is still the best-performing asset class that can comfortably continue to dominate.

Nor was I trying to say that European equities are sure to post above-average returns over the next few years and you should move all your money into them. Quite the contrary, the examples in this blog have tried to show that the market often turns our assumptions about the best investments completely upside down.

The same thing applies to bonds. Although they currently have above-average returns, over the long term they are still an asset class with lower expected returns than equities. If you have decades to multiply your assets and can tolerate the occasional downturns, you're still better off with an equity portfolio. If you chase a quick return in the belief that bonds will outperform stocks for years to come, you may be left disappointed if you miss a strong stock market recovery.

Last but not least, this article was not trying to say that you can't beat the market by picking titles. There will always be a few successful investors. But statistics show that it is a small fraction of those who try. Do you believe you are the new Warren Buffett? Remember that overconfidence bias is a documented investment mistake in behavioral finance.

If not, take advantage of the magic of diversification. You never know which investment will hold the reins of growth, so hold them all and your share of humanity's profits will not pass you by. In the meantime, you can focus on income growth and personal development in a sphere that fulfills you.