Financial advisors – myself included – invariably extol the virtues of diversification. “Investors must be diversified!” we declare. (See here, here and here.)
And why wouldn’t we? Diversification improves portfolio returns. Diversification reduces your portfolio’s risk. Diversification truly is the only “free lunch” in investing.
However, beneath that happy veneer lurks a downside, one rarely mentioned by financial advisors, but a downside that threatens some investors with completely undoing all of the virtues of diversification – and even leaving investors with worse returns than if they had used an undiversified portfolio.
So what is this danger lurking in the happy world of diversification? It’s what is known in finance circles as tracking error.
For stocks, tracking error is simply the amount by which the performance of a portfolio’s stock allocation varies from that of well-known market benchmarks, in particular the Dow and the S&P 500. Basically, how well are the stocks in your portfolio doing compared to the Dow or the S&P, which are the benchmarks that people read and hear about.
The more diversified your portfolio is in terms of stocks, the more tracking error you take on. And that can be a dangerous thing to do because behavioral finance has shown over and over that while few investors notice when tracking error is positive (their diversified stocks beat a benchmark), many investors care a lot – a whole lot – when the tracking error is negative.
And guess what, sooner or later, the S&P 500 or the Dow will outperform a diversified portfolio of stocks. It’s not a question of if that will happen, but a question of when and for how long.
Indeed, I know all of this from personal experience as we just went through such a period.
So let’s match up a portfolio that I might construct for a client – we’ll call it the Oh-So-Diversified Portfolio – against one that holds only the S&P 500 for its stock allocation – the This is What I Hear About on TV Portfolio. Both portfolios will be 60% stocks and 40% bonds with bonds being the same (Treasuries). The stock portion of the Oh-So-Diversified Portfolio will be diversified across countries (we’ll keep about 40% of our stocks in foreign companies) and factors (we’ll hold large companies, small companies and value companies).
From May 2010 to May 2012, our Oh-so-Diversified Portfolio was trounced by the undiversified This is What I Hear About on TV Portfolio, which earned 5.81% annually compared to our 1.62% annual rate of return.
But how can this be? How can a well-constructed, diversified portfolio get beat by an undiversified portfolio – for two years, no less?
Because here’s the thing about being diversified across many countries and parts of the stock market: Some part of the market somewhere around the world is always doing better than the others, so it’s a guarantee that your diversified collection of stocks will always be “underperforming” some sector. Now, if that part of the global stock market is small cap stocks in Germany, well, it’s unlikely that you’ll notice. But when that part of the market is the S&P 500, you’ll notice. Whether you care or not is the question.
If trailing the S&P 500 for a day, a week, a month, a year or any other time period causes you to lose sleep or, much more importantly, to question your investment strategy, you strongly should consider whether owning a diversified portfolio is right for you. While not an optimum strategy, keeping the entire stock allocation of your portfolio in the S&P 500 is a perfectly reasonable choice, especially if it allows you to stick to your plan and weather the eventual ups and downs of the stock market.
Will it cost you some higher returns over the long run? Very likely. But if holding only the S&P 500 allowed you to avoid bailing out on the Oh-So-Diversified Portfolio in May 2012, it would have been worth missing those extra returns.
There is a downside to diversification. Much like being the casino owner, you have the odds dramatically on your side with a diversified portfolio over the long run, but, on any given night (or, in our case, any given several year period), you might lose. You also have to live with the fact that you’ll never hit the jack pot. So what do you get in return for your patience?
Well, from 2000 to the end of 2012, the Oh-So-Diversified Portfolio earned 6.70% a year. The This is What I Hear About on TV Portfolio earned an anemic 3.23% a year. If you started with a $500,000 portfolio in 2000, it would have grown to $1.16 million with the Oh-So-Diversified Portfolio. If you used the This is What I Hear About on TV Portfolio, it would have grown to $755,870, a difference of $405,000.
Diversification works, but only if you stick with the plan. And you can only stick with the plan if you understand why the plan works.
Mark on Money 