Nineteen years ago this month, Eric started working with Ruth at her LPL Financial branch in Inverness. While Ruth had much to teach Eric, he was also getting a firsthand lesson on the importance of a diversified portfolio.
On March 10, 2000 the Nasdaq Composite Index, which is heavily weighted towards technology companies, closed at an all-time high of 5,048 points. It was just 5 years earlier that the index closed above 1,000 points for the first time. During this meteoric rise, many abandoned their diversified portfolios to chase the higher return of tech stocks. Money Magazine famously touted in May of 1999, “Tech Stocks: Everyone’s Getting Rich!” and many took their advice on “how to get your share”. 1
Even as the Nasdaq peaked, there were few experts openly advocating for a more rational investment approach. The CNN Money market report from that evening speaks of the Nasdaq with phrases like “analysts see the trend continuing”, “analysts scrambling to upwardly revise forecasts for the index”, and a chief technical analyst saying “the Nasdaq could hit 6,000 before the end of next year”. Meanwhile the report refers to the Dow Jones Industrial Average (index of 30 large US companies) as having “too many stocks whose time has passed” and “old economy”.2
History didn’t quite turn out that way. The dot-com bubble burst and over the next two and a half years the Nasdaq Composite Index fell 78% to 1,114 points on October 9, 2002.1
While we don’t see any bubbles today, we do think there is a similar trend of moving away from diversification in search of higher returns. This trend is towards US large cap growth stocks – think of the largest and most well-known companies in the country.
As our Q2 2019 Quarterly Market Review outlines, US large cap growth stocks (Russell 1000 index) have an annualized return over the past 10 years of 16.28% (remember 10 years takes us back to just after the financial crisis, which is why this number is so much higher than long-term stock return averages).
Large cap stocks abroad have not had nearly the same level of returns – 6.75% for international developed large cap (MSCI World ex USA Index) and 5.81% for emerging market large cap (MSCI Emerging Markets Index).
Small cap returns also pale in comparison to US large cap growth. 10-year annualized returns are: 13.45% US small cap (Russell 2000 index), 9.19% international developed small cap ( MSCI World ex USA Small Cap Index) and 5.86% emerging market small cap (MSCI Emerging Markets Small Cap Index).
We highlight these differences, not to predict the future performance of US large cap growth stocks, but to affirm the diversified approach we take in the portfolios we manage. A recent blog post, Perspective on Premiums, goes further into this analysis.
We also want to highlight that diversification is not always what it seems. Holding the largest 500 US stocks, a.k.a. the S&P 500 index, would seem like reasonable diversification. A closer look can reveal some limitations to this approach. The S&P 500 does not include small cap or international stocks. It also does not hold each of the 500 stocks equally, they are held weighted based on market capitalization (size).
For example, let’s suppose the top 50 stocks in that index were down 5% and bottom 450 stocks were up 5%. This means that 450 of the 500 stocks were up. Would the index be higher or lower? Common sense would say the index should be higher if 90% of the stocks were higher. The index would actually be flat. This is because the largest 50 stocks represent half of the index while the other 450 stocks represent the other half.
In contrast, the stock portion of the portfolio we manage on behalf of our clients has exposure to over 13,400 stocks including the large, mid and small cap segments of US, international developed and emerging markets. You can read more about Why We Use Dimensional Funds for more details.
Nobel Prize winning economist Harry Markowitz called diversification “the only free lunch in finance”. We whole-heartedly agree. Let us remember this as we look at historical returns and current market conditions, as well as remembering that the portfolios we construct for clients are based upon theoretical and empirical evidence that support diversification and are also held in a balance that we believe is appropriate for your individual situation.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
The hypothetical example provided is not representative of any specific investment. Your results may vary.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Investing involves risk including loss of principal. No strategy can provide success or protect against loss.