Trust Services and SIMPLIFY
A common perception today among investors is that diversification hasn’t worked because diversified portfolios have delivered lower returns than U.S. stocks in recent years. Yet, that’s exactly how diversification should work.
A diversified portfolio will always underperform the best performing asset class, which lately has been U.S. stocks. This is why diversification should not be viewed as a return enhancer, but rather a risk management tool that can reduce risk without necessarily reducing absolute returns (the return that an investment earns independent of any benchmark). However, diversification comes with tradeoffs. Diversifying may cause you to risk experiencing lower relative returns (the return that an investment earns relative to a benchmark) for a period of time.
To help understand diversification’s tradeoffs, let’s look at a simple comparison. Imagine that you’re a Florida resident whose friends have beach house rentals that yield 10% a year. Now imagine that you have the opportunity to earn the same yield as your friends by investing in either 1) two Florida beach houses or 2) one Florida beach house and one Tennessee mountain cabin. If you choose the latter, you’ll mitigate risks specific to Florida beach houses (like hurricanes), without affecting your expected return. However, you’ll also more likely experience different returns from your friends who own only Florida rentals. For instance, a property tax hike or overbuilding in Tennessee could reduce your cabin rental’s yield, or vice versa. The point is that diversification is a great risk management tool, but it can cause discomfort when part of the portfolio lags.
At Ronald Blue Trust, we believe diversification is a critical element to investing due to the unpredictability of markets and economies. If we knew the future, we would concentrate in the asset class that would perform best; unfortunately, the future is uncertain and unstable. This means that asset classes routinely cycle from beloved to despised, and vice versa. The 2000s, for example, illustrate this phenomenon. You can see in the chart below that from 2000-2009, the S&P 500 declined around 1% per year on average but, in the seven years since, the S&P 500 has returned almost 13% a year. In contrast, emerging markets climbed over 10% a year in the 2000s, but have grown less than 1% a year since.
While diversification ensures that we don’t pile in to an asset class that ends up performing poorly, it also means that we won’t hold only the best performing asset class. This narrows the range of possible outcomes and improves the likelihood of successfully achieving our return goals. It also means that when a popular benchmark outperforms most other asset classes, a diversified portfolio will lag. We believe this concept is important for investors to understand. Otherwise, they may grow frustrated and abandon diversification, only to get whipsawed shortly thereafter as the benchmark starts lagging other asset classes. Diversification is not for everyone, but if you can get comfortable with discomfort, diversification is an excellent hedge against an unpredictable future.
At Ronald Blue Trust, we believe that a principled approach to investing and a commitment to a strong investment process are essential for investment success. If you’d like to learn more about our investment philosophy, please contact a Ronald Blue Trust advisor by calling 800.987.2987 or emailing
Be sure to visit our
channel and follow us on
Disclaimer: Ronald Blue Trust obtains historical and other information from a wide variety of publicly available sources. The information and material provided is for informational purposes only and is intended to be educational in nature. We have taken reasonable care and precaution to ensure that the information is fair and accurate, or has been compiled from sources believed to be reliable. Nevertheless, we do not make any representations or warranty, express or implied, as to the accuracy, completeness, or fitness for any purpose or use of the information. The information may not in all cases be current and it is subject to continuous
change. Accordingly, you should not rely on any of the information as authoritative or a substitute for the exercise of your own skill and judgment in making any investment or other decision. We recommend that individuals consult with a professional advisor familiar with their particular situation for advice concerning specific investments, accounting, tax, and legal matters or other matters before taking any action. We shall not be liable for any direct, indirect, or consequential loss arising from any use of or reliance on the information contained here. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Investing involves risk and the value of your investment will fluctuate over time and you may gain or lose money. Past performance of any security, sector or investment style is not necessarily indicative of future results.