Is there a downside to diversification?
Which would you have rather owned A or B? A lost an average of almost 1% per year for the decade January 2000-Decemeber 2009 but returned almost 13% per year from January 2010 through June 2023. Cumulatively, A averaged a 6.84% annual return for the period January 2000 through June 2023.
B on the other hand gained an average of 12.26% per year for the decade January 2000-Decemeber 2009 and returned 11.44% per year from January 2010 through June 2023. String those returns together and the result is B averaged a 11.79% annual return for the period January 2000 through June 2023.
B had the higher return over the entire 2000-2023 period and the more consistent result in each sub-period. Further, if we look at each calendar year return, we see that of the 23 calendar years starting with 2000, B lost more than 10% in just 3 of those years while A dropped that far 4 times. Looking at strong positive years in which the returns exceeded 20%, B eclipsed that threshold 9 times but A only 6.
B certainly looks superior. So why is A the far more popular choice than B right now?
It’s simple. A has been doing better lately.
We are all prone to cognitive biases. One of them is called “Recency Bias.” This pops up when we take recent performance and assume it will continue. We assume a poorly performing holding will continue to be weak or a strong performer will continue to make us money. (Read what Charlie shared on recency bias with CNBC here.)
The result can be chasing returns, buying more of what has been hot lately, and it is detrimental to our results over time.
Most mutual fund investors don’t do as well as the funds they invest in largely because they buy more after the fund has gone up and sell after it has fallen in value. The annual “Mind The Gap” report from Morningstar calculates the difference between mutual fund returns and the returns actually achieved by investors, i.e. “the gap”. This year’s report puts the gap at 1.7% per year on average over the decade ending December 2022. The more volatile the funds, the bigger the difference, so funds that invest in stocks tend to outperform their investors by even more due to the effects of returns chasing.
Trying to determine whether A or B will be better in the short run and moving money between the two based on one’s forecast is closer to speculating than investing. A great approach to truly investing is to buy both A and B because both have good long-term prospects. They are prominent indexes of two very different portions of the markets. A tracks large U.S. companies and B tracks small U.S. companies whose stock prices have been weaker than those of small U.S. companies generally. You cannot invest directly in an index, but you can invest in funds that track the indexes and will get you very close to the return of the index. Once you buy both, rebalance periodically.
If one had simply split their funds between A and B and every year sold enough of the better holding to buy the weaker and get the split back to 50%, the returns would have been pretty good too. From 2000-2009 the 50/50 mix returned just shy of 6%. That’s better than A but not as good as B. The 50/50 blend earned 12.42% since 2010 – better than B but not as good as A. The average for the full 2000-2023 period was a solid 9.63%. Yet no prognosticating was required. All that was needed was the discipline to rebalance by buying the holding that looks the weakest and the patience to be rewarded for the risk taken.
A downside to being diversified is you will always have portions of the portfolio that won’t look as good as others over any period you examine.
A downside to being diversified is you will always have portions of the portfolio that won’t look as good as others over any period you examine. If you do not accept this as the normal state of a good portfolio, you can be tempted to tweak things and that often hurts more than it helps.
The most reliable way to navigate markets over the long term has been and should remain to invest, not speculate. Stay diversified, patient and disciplined and a better than average result is the likely outcome.
We continue to help various media outlets provide sound information to their audiences. (Some links may require a subscription to view.)
Charlie Fitzgerald, CFP®, Derrick Chandler, CFP®, Tommy Lucas, CFP® EA and Casandra Garrett, CFP® participated in a call-in event last October for the Orlando Sentinel. The Sentinel has highlighted several of their responses since then in its “Ask An Expert” feature. In July they included Charlie’s explanation of the tax consequences of gifting funds to a child.
In the News…
MFT was named to Financial Advisor magazine’s list of the top Registered Investment Advisory firms in the U.S. The list is based on assets under management.
If you are a member of an organization in need of a personal finance speaker, we are happy to talk with your group’s organizers about helping out at no cost.
Dan Moisand’s service as 2023 Chairman of the Board of Directors of CFP Board, the body that confers and administers the CERTIFIED FINANCIAL PLANNER™ and CFP® credentials for the 96,000+ CFP® professionals in the U.S., has him speaking at several events and conferences during the year. He recently spoke at the Far West Roundup on the campus of the University of California at Santa Cruz.
Things We Found of Note
56% of workers are concerned about their job security (CFP Board Sentiment Survey)
82% of working Americans are concerned about their ability to save for their future (CFP Board Sentiment Survey)
$36 billion Estimate of amount lost to scams by seniors in 2022 (Think Advisor)
1 in 42 Estimated number of fraud cases involving seniors that were reported (Think Advisor)
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