Building Resilient Portfolios: The Power of Diversification

Reduce concentration risk

U.S. Large Cap stocks have experienced a remarkable run-up in value since the 2008 financial crisis. Their outperformance was facilitated by fiscal stimulus, record low interest rates, and strong corporate earnings. Following the onset of the Covid pandemic, tech-focused companies, led by giants like Amazon, Apple, and Microsoft, became the dominant force in driving the market’s overall gains. Investors who had large allocations to these companies were handsomely rewarded.

But tech stocks didn’t do so well in 2022 (although they have recovered some ground since) and portfolios that were heavily weighted in those names would have felt that downturn far more than portfolios that had a healthy mix of large cap, small cap, and international stocks, as well as bonds.

Employing a diversified investment strategy can help investors create a balanced portfolio that avoids overconcentration in any given asset class.

Historical data show that there has never been one consistent asset class that you can bank on to always get you the best return, and there’s no way to predict at the start of the year how the next 12 months will unfold. Since we know consistently picking the best performing asset class is not a realistic strategy, the next best option is to diversify your holdings to avoid overconcentration in a single asset class, never miss out on the year’s leading asset class, and potentially smooth out returns over time.

Overcoming home country bias for portfolio diversification

Many investors, knowingly or unknowingly, tend to overconcentrate their portfolios in the regions or companies that they are most familiar with. Their thought pattern may run along these lines: “I know plenty more about the economic conditions and current market environment of my home because I am actively participating in both.” Investing in this way is a tendency known as “home country bias” and can be a roadblock to having a fully diversified portfolio. A U.S. investor sticking to just U.S. equities will limit their investment opportunities because U.S. equities only make up about 60% of the world’s market cap.¹

But as we noted earlier, U.S. investors have benefitted from home bias and U.S. overconcentration in the past decade as the chart below shows.

As you can see, U.S. Large Cap stocks were in the top three asset classes in any given year over the last decade and recorded the best annualized return over the period. It’d be easy to use this as a reason to maintain an overweight to U.S. equities, but markets change, and all asset classes cycle in and out of peak performance.

For example, the chart below shows the 10 years preceding the last decade. In this 2003-2012 period, U.S. Large Cap stocks were never the top asset class, and on an annualized basis lagged Emerging Markets, the top performing asset class, by nearly 10%. The next decade could look the same as this one, the current one, or end up wildly different, since past results are no guarantee of future performance. And since we don’t know what the future holds, owning a diversified mix of asset classes can help ensure your portfolio always has a chunk dedicated to each year’s top performer, no matter where we are in the market cycle.

May help smooth out returns in volatile times

A properly diversified portfolio is comprised of investments whose returns do not move perfectly in the same direction, or with the same magnitude. The idea behind this approach is to help smooth out portfolio returns. Let’s take a look at how a diversified portfolio comprised of a variety of equities, Real Estate Investment Trusts (REITS), commodities, investment grade bonds and high-yield bonds performed compared to U.S. large cap stocks in 2022. As you can see, the diversified portfolio was less volatile even though it too had a rough year, all things considered. More importantly, however, is that because it fell far less than U.S. large cap stocks did, it has had less ground to make up in 2023.

Smoother returns may help investors sleep better at night. And it may help them avoid pitfalls of emotionally based investment decisions. Sometimes investors see their portfolios fall in value and panic, then move to cash to avoid further losses. But doing so locks in the decline and means they then have to look for the best point of re-entry. Without a crystal ball, however, they may end up buying back in at the wrong time and miss some or all the market’s rebound. This is contrary to the principle of successful investing: buy high and sell low.

The bottom line

Diversification is a tool to help mitigate risk in a portfolio so you can navigate all market environments while keeping focused on a long-term goal. U.S. Large Cap stocks may continue to lead the markets in the next few years – or they may not. History has shown us that market leadership eventually changes. No one can predict when that change will occur, nor which asset class will emerge as the leader. The best we can do is prepare for all potential outcomes with a diversified portfolio.

¹ Source: Morningstar: MSCI All Country World Index

Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.

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Bloomberg U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (specifically: Bloomberg Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index).

Bloomberg Commodity Index Total Return: Composed of futures contracts on physical commodities. Unlike equities, which typically entitle the holder to a continuing stake in a corporation, commodity futures contracts normally specify a certain date for the delivery of the underlying physical commodity. In order to avoid the delivery process and maintain a long futures position, nearby contracts must be sold and contracts that have not yet reached the delivery period must be purchased. This process is known as "rolling" a futures position.

FTSE EPRA/NAREIT Developed Index: A global market capitalization weighted index composed of listed real estate securities in the North American, European and Asian real estate markets.

MSCI EAFE (Europe, Australasia, Far East) Index: A free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.

MSCI Emerging Markets Index: A float-adjusted market capitalization index that consists of indices in 24 emerging economies.

MSCI World Index: A broad global equity index that represents large and mid-cap equity performance across 23 developed markets countries.

The Russell 3000® Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.

The S&P 500® Index: A free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500® are those of large publicly held companies that trade on either of the two largest American stock market exchanges: the New York Stock Exchange and the NASDAQ.

Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Diversification does not assure a profit and does not protect against loss in declining markets.

Past performance does not guarantee future performance.

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