Why (and How) Diversification Works

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. (For more, see: The Importance of Diversification.)

A Comparison

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.

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. (For more, see: Introduction to Investment Diversification.)