Column: The Return of Diversification

For years I have strongly recommended that clients diversify their portfolios by investing in a variety of asset classes - such as large and small cap stocks, bonds, international stocks, etc.

Research has shown that over the long run, investors who pursue a diversified portfolio strategy are more likely to reach their long-term financial objectives, while smoothing out at least some of the erratic leaps and dives in portfolio value that are an uncomfortable fact of life in the financial markets.

Indeed, by combining different assets in the right proportions, investors may be able to build portfolios that produce higher returns - at lower risk - than they could obtain by investing in any single asset by itself.

Diversification also allows investors to control the amount of risk they take in their portfolios. A retired investor, for example, might chose to allocate a larger fraction of his or her portfolio to bonds or other fixed-income securities, compared to a young couple just starting out. Such a portfolio probably would earn lower returns, but also would be less likely to experience drastic short-term swings in value compared to a portfolio heavily weighted with, say, small technology stocks.

Given the benefits, you would think diversification would be an easy sell. Yet, in recent years, many investors have reacted to suggestions that they diversify their holdings like kids who have been told to eat their spinach. After all, spinach may be good for you, but how many kids would eat it if they could have all the candy they want instead?

The candy, in this case, has been the market for large U.S. stocks, particularly in the high-flying technology sector. Between 1995 and 1999, the S&P 500 Index - a popular benchmark for large stocks - returned an average 29 percent per year. Some large tech stocks easily doubled or tripled that figure. Under the circumstances, many investors didn't see any need to diversify- especially at a time when several other asset classes, such as the emerging stock markets of Asia and Latin America, were performing relatively poorly.

For several years, these investors could, by and large, thumb their noses at those sticks-in-the-mud who insisted on eating their 'spinach.' Diversified portfolios persistently lagged behind the S&P 500.

With the U.S. economy racing into the Internet era, the idea of investing in anything other than the largest of large U.S. stocks began to seem about as quaint and old-fashioned as owning an 8-trak tape deck.

Now, fast forward to the middle of this year. Suddenly the picture looks very different. The bull market in large US stocks may not be over, but it has stumbled. The Nasdaq Composite Index, almost completely dominated by big tech stocks, ended the first half of 2000 with a 2.54 percent loss. The S&P 500 lost 0.42 percent. Meanwhile, other asset classes - such as small-cap stocks and long-term Treasury bonds - have moved to the front of the pack. These changes in fortune have had a dramatic effect on the relative performance of diversified portfolios versus the S&P 500. Many of our diversified portfolios have drastically outperformed the S&P 500 Index year to date.

But the true merits of any investment strategy can't be measured over such brief periods. (If they could, then last year's results would have proven the wisdom of investing in nothing but the stocks of small, money-losing Internet companies.) Rather, investors need to look at performance over a reasonable long-term horizon.

Return is only half the equation, however. I feel you also need to be concerned about risk. One of the key benefits of diversification is that it can reduce portfolio volatility, because returns on different assets may offset each other over time. For example, when US stock prices are going down, foreign stock prices may be going up, or vice versa.

Of course, this doesn't mean large U.S. stocks are no longer worth owning - or that a diversified portfolio will never again lag the S&P 500. Given their high historic returns, ample liquidity and low transaction costs, large U.S. stocks are likely to remain the core asset class in most portfolios.

But investors should understand the past few years have been the exception, not the norm. The economic environment has been almost ideal for large stocks, allowing the S&P 500 to rise 250 percent in just five years, a feat unequalled in nearly 75 years of stock market history.

Experience teaches me that the playing field rarely is tilted in favor of any single asset class for so long a time. Now that the U.S. economic outlook has become less certain, it wouldn't be too surprising if the S&P 500 delivered returns that look more ordinary over the next few years. In other words, the candy store may be closing.

By diversifying now, investors can put themselves on a more balanced financial diet. While it may not taste as good as candy, its much more likely to help their portfolios grow up big and strong. For information on how to diversify your portfolio, call me, Bill Creekbaum, CFP at 689-8720 or e-mail me at William.a.Creekbaum@rssmb.com.