“You keep using that word. I do not think that it means what you think it means,” Inigo Montoya, The Princess Bride.
The word “diversification” gets thrown around a lot in the investing world. Everyone agrees that it’s important and that everyone should be diversified. The problem is that there’s no one definition of diversification.
Does it mean owning 50 stocks instead of one? Well, yeah. That’s a form of diversification.
Does it mean owning different sectors of the economy? Sure. That’s another form of diversification.
Does it mean owning some bonds as well as stocks? Yep. That’s diversification too.
Unfortunately, that’s about as far as most Americans go on their diversification journey. This is a mistake. Indeed, a mistake that could cost them hundreds of thousands (if not millions) of dollars and leave them broke in retirement.
American investors could improve their returns and, more importantly, dramatically reduce the risk of not meeting their goals by adding geographic and “Strategy” diversification.
Strategy Diversification
So, what the heck is Strategy diversification? (I’m assuming that most people understand what geographic diversification means. Own stuff in other countries!) Strategy diversification simply refers to employing different investment strategies.
For example, the S&P 500 is comprised of big American stocks. That’s a strategy. (Yes, the S&P 500 isn’t anything special. It’s an investment strategy like any other. A pretty good – though not great – strategy, but a strategy nonetheless.) A different strategy might be owning small American stocks. Another strategy might be buying cheap or value stocks. Astute readers might notice that I’m talking about “Factor” investing. (For a discussion of Factor investing, see this, this and this.)
Another strategy might be using a trend screen on your stocks to decide when the odds are in your favor so you stay invested and when the odds are against you so you get out of the market. (For a discussion on the use of a trend screen see here and here.) Using a trend screen is, of course, a very different from the strategy than buy and hold.
(Again, I know that buy and hold has been sold as THE one true way to invest. Heck, I’ve preached it for decades. But the truth is that buy and hold is just one strategy among many. Granted, it’s a very, very good strategy, but like any strategy, it has its strengths and weaknesses. The same is true for using a trend screen.)
Diversification Throughout the Decades
So, let’s take a look at how geographic and strategy diversification has helped investors over the decades, indeed, saved investors in some decades who traditionally use only the S&P 500 and bonds. In this case, we’ll use five-year Treasury bonds for our bond investment.
(Please note that I’m going to use annualized real returns, i.e. how well an invest did after adjusting for inflation. I mean, who cares if an investment makes 10% a year if inflation is 20% a year.)
To represent geographic diversification, I’ll use the MSCI ex-US index. Think of this as the S&P 500 for the rest of the world. For strategy diversification, I’ll use Dimensional Fund Advisors U.S. Small Value Index and a combo of their International Small Cap and International Small Value Indexes.* This will show the impact of investing in small and value stocks. For the trend screen strategy, I’ll use a 10-month moving average trend screen on the S&P 500 where we move to cash when the S&P 500 falls below its 10-month moving average.
Finally, to see how a truly diversified portfolio would have performed, I will include the annualized real returns of a portfolio equally weighted among each investment asset and strategy.
1970s
S&P 500 | 5-Yr Treasury | MSCI | US SV | Int’l SV | Trend | Diversify |
-1.5% | -0.4% | 3.5% | 6.8% | 16.0% | 0.9% | 5.4% |
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
As you can see, the 1970s were a disaster for American investors who lacked geographic and strategy diversification. Both the S&P 50 and Treasury bonds lost you money over the decade. Those negative real returns were a financial death sentence for retirees pulling money out of their portfolio. Had those retirees included international, small and value stocks, they would have been fine.
1980s
S&P 500 | 5-Yr Treasury | MSCI | US SV | Int’l SV | Trend | Diversify |
12.5% | 6.8% | 16.4% | 15.0% | 27.0% | 11.4% | 15.5% |
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
Well, that’s more like it. Frankly, you almost had to try to lose money in the 1980s. That said, geographic and strategy diversification (small and value stocks) were the clear winner for this decade.
1990s
S&P 500 | 5-Yr Treasury | MSCI | US SV | Int’l SV | Trend | Diversify |
15.3% | 4.3% | 4.5% | 13.5% | 0.4% | 10.2% | 8.6% |
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
The 1990s was the S&P 500 decade. It rolled over everything. Geographic and strategy diversification were a drag on performance. However, the equal weight portfolio continued to perform well, showing that diversification works.
2000s
S&P 500 | 5-Yr Treasury | MSCI | US SV | Int’l SV | Trend | Diversify |
-3.5% | 3.7% | -0.5% | 9.9% | 11.0% | 5.4% | 5.4% |
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
Ouch! Like the 1970s, the 2000s were an absolute disaster for your typical American investor. The S&P 500 lost more than 3% a year after inflation. Once again, anyone retiring in the early 2000s and relying on the S&P 500 to grow their portfolio found themselves in a world of hurt. Thankfully, bonds picked up some of the slack but likely not enough. But look what saved the day: Strategy diversification. Small and value stocks did fantastic as did using a trend screen to mitigate the crashes of 2000-2002 and 2008-2009.
As usual, the Diversified Portfolio did perfectly fine.
2010s
S&P 500 | 5-Yr Treasury | MSCI | US SV | Int’l SV | Trend | Diversify |
11.3% | 1.2% | 3.7% | 9.3% | 4.9% | 5.0% | 6.2% |
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
Hmm, the 2010s look eerily like the 1990s. The S&P is blowing away everything. Geographic and strategy diversification are hurting us, but the S&P 500 and U.S. small value stocks are enough to buoy the diversified portfolio’s returns.
True Diversification Works
The lesson from history seems pretty clear. Owning the S&P 500 isn’t enough diversification. Owning the S&P 500 and bonds isn’t enough diversification. Investors need to incorporate geographic and strategy (factors and trend) diversification into their portfolio, or they risk a decade-long period of no returns above inflation.
*Dimensional International Small Cap Index from 1970 to 1981. Dimensional International Small Value Index from 1981 to 2019.