Stocks and Bonds Aren’t Enough: You Need Strategy and Geographic Diversification as Well

“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.

About Mark Helm, CFP, EA

Mark Helm is a Certified Financial Planner and Enrolled Agent. He is the founder of Helm Financial Advisors, LLC, a fee-only financial planning firm dedicated to helping people reach their life goals.
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2 Responses to Stocks and Bonds Aren’t Enough: You Need Strategy and Geographic Diversification as Well

  1. Bill Prosser says:

    US SV outperformed diversify in every decade except one, and in that one decade US SV performed very well and was out performed by Diversify by only 0.5%. Based on this information, it would appear that rather than diversify we should invest in US SV. I am interested in your reaction to this statement.

    • Bill,

      Thanks for the interest. I also noticed the consistency of the US Small Value (US SV). It seems when U.S. stock market premium (S&P 500) were getting hit, the small and value premiums picked up the slack and vice versa. Diversification at work. That said, comparing just the returns of US SV to the diversified portfolio omits a major issue: Risk. Granted, due to limits on space, I didn’t show this in the blog post, but how it felt to earn the returns on US SV and the diversified portfolio was dramatically different.

      From 1970 to June 2019, Dimensional’s US SV index earned 14.8% a year nominal compared to 12.1% a year nominal for the diversified portfolio. Therefore, US SV is the winner, right? Not so fast. Your US SV portfolio lost 20% or more of its value ten times over those 50 years! Yikes. Could you handle 20%+ drops in your portfolio every fives years or so. I can’t. What’s the more, the US SV portfolio lost almost 50% of value in 1973-74 and more than 60% of its value in 2008-2009. Not many people can deal with that.

      The diversified portfolio only lost 20% or more of its value twice – 24% in 73-74 and 38% in 2008-2009. By any definition, the diversified portfolio is a far safer portfolio than the US SV portfolio, but its returns are just a bit lower. So, on a risk-adjusted basis, the diversified portfolio is much superior while being only slightly worse on a pure return basis.

      The other answer to that question is that just because US SV was the best over the last 50 years in pure returns, that doesn’t mean that it’ll be best over the next 50 years or, more importantly, ten years. Unless we know the future – and we don’t – it’s best to diversify among proven assets and strategies, figuring that some will do well and while some lag.

      Hope this helps,
      Mark

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