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Patton Wealth Management, Inc.

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The Diversification Opportunity

This could be the most important graph you see in a decade!

This is a simple and powerful concept. The higher the blue line on the graph, the more likely that you will benefit from more diversification in your portfolio.

Executive Summary

  • A powerful long-term cycle of large U.S. stocks dominating performance could be shifting with potentially huge implications for investors
  • Large U.S. stocks have been the leaders in the current bull market but history has shown this comes and goes over time
  • The recent long-term bull market has left many investors forgetting the pain inflicted during bear markets and with too much invested in large U.S. stocks
  • The average advisor recommends more than a 50% allocation to stocks which presumably is concentrated in U.S. stocks
  • You cannot time the market and market declines often happen fast and without warning
  • A diversified and resilient portfolio is always the answer…and more so than ever now!

I love diversification! Not just traditional diversification into stocks, bonds, and cash but including a wide range of investments in what we call Super-Diversification. Our U.S. Securities and Exchange Commission, the SEC, discusses diversification under the heading of “The Magic of Diversification”. They do this because, when done properly, it can meaningfully reduce risk in a portfolio without giving up long-term upside.

We will get back to the above graph later and provide more details and explanation but let’s first consider one of the biggest challenges for most investors as it pertains to diversification.

Large U.S. Stocks are most often a Portfolio’s Foundation

Large U.S. stocks tend to be the starting point for any great long-term portfolio. This is especially true for American investors due to what economists call a home bias or the tendency for people to invest more in their home country.

Investors’ focus on large stocks is natural and nearly unavoidable. When you turn on CNBC they show the S&P 500, Dow Jones, and NASDAQ in the bottom right corner. These are all stock market indices for large U.S. stocks. Articles on investing most often discuss these same indices, your investment statements likely report these indices, and business news stories tend to focus on the largest companies. These companies also are the more commonly known brand names such as Apple, Amazon, and Walmart, creating a level of comfort and perceived safety for investors.

Not only do large U.S. stocks get the most attention and consist of the most recognizable names but they have also performed very well long-term. Capturing some of this strong performance is naturally enticing for investors. Therefore, given our natural tendency for a home bias, the attention put on large U.S. stocks and the recognizable company names, combined with strong performance, again, portfolios tend to start with a foundation of large U.S. stocks.

Diversification then becomes about diversifying away from large U.S. stocks. It's a tug-of-war between large U.S. stocks and Everything Else in the portfolio! The following table shows what I’ve defined as Everything Else for the purpose of this analysis. Note that Berkshire Hathaway is used as a proxy for private equity investing.

This is not simply theory but plays out in real time for investors. One example is the average advisor, according to the September 2019 issue of Investment Advisor magazine, recommends an allocation of more than 50% to stocks.

Furthermore, when looking at mutual funds, the most popular investment vehicle for investors and generally recommended by advisors, and the amount of money invested in various types of funds, 79% of all money in U.S. stock focused funds are in large U.S. stock funds. Clearly large U.S. stocks are highly popular for investors.

Not only are large U.S. stocks the starting point when building a portfolio but clearly a large majority of portfolios end with these stocks being their largest allocation.

Large U.S. Stocks have only recently been the BIGGEST winners

The accompanying table provides a summary comparison of the performance of large U.S. stocks and Everything Else since 1972. As you can see, large U.S. stocks have been the Winners during the 2009 – 2019 period but this is not always the case.

The performance of large U.S. stocks relative to Everything Else has ebbed and flowed for this nearly 50 year period. Performance seems to be persistent when the winds shift often reaching extremes before reversing. To see detailed performance for each of the various time periods, click the below button.

See Performance Cycles Details

What’s next?

What should we expect in the coming years? Will the most recent decade’s trend continue with large U.S. stocks outpacing Everything Else? Or is the past decade just part of a very long-term cycle that may see the winds shift at some point? There’s no way to know for sure but research and analysis suggests the winds may have a high probability of shifting and possibly sooner rather than later.

Let’s get back to The Diversification Opportunity graph we started with. See below. This graph illustrates the cycles just highlighted in the previous four graphs. It shows the rolling 10-year performance of large U.S. stocks versus Everything Else.

Graph Calculations and Explanation

When the trend is toward the top of the graph, when the blue line is high, large U.S. stocks have been performing better than Everything Else. This was the case in the late ‘90s, toward the middle of the graph, and the same currently on the right side of the graph. Again, these are times when we have just completed a decade or longer run of large U.S. stocks performing better than Everything Else.

On the contrary, when the blue line is toward the bottom of the graph, as it was on the far left in the early ‘80s and then again toward the middle to right of this graph around the 2009 – 2010 period, large U.S. stocks have lagged behind Everything Else. Again, this was the case for the years leading up to the early ‘80s and again from 1999 – 2009.

Now, as always!, is a Great Opportunity for Diversification

I believe that being diversified is always the best approach! This is a proven strategy. That said, there are times when the opportunity to diversify may be better than others and today, based upon this research, could be one of those times.

During the past decade from 2009 through today, large U.S. stocks have outperformed Everything Else by a wide margin…one of the widest margins in history (blue line currently high on the graph). This means that a portfolio consisting of anything other than large U.S. stocks faced somewhat of a headwind. Diversification still worked during this decade but performance was not as strong as during other periods.

The past 10-year outperformance by large U.S. stocks does not guarantee that this trend comes to an end now. There is no way to know the future but history would suggest that such long periods of extreme outperformance by one asset class tend not to last forever. I do believe that this research, and the apparent cycles, suggests that a well-diversified portfolio could see the wind to its back over the next many years.

This research, and my opinion, is not suggesting or trying to predict a bear market or to time the market in any way. Instead, I believe the research simply shows other asset classes in a portfolio, Everything Else, may potentially drive the performance of portfolios in the coming years.

What does this mean for investors?

This could have huge implications for all investors regardless of your risk. We all tend to get attracted to that which has recently performed the best and avoid those things that have not performed as well. Therefore, investors may be overloaded with large U.S. stocks today. If the cycle does shift, portfolios overloaded in large U.S. stocks could deliver very disappointing returns.

See Portfolio Returns Here

But what if the cycle does not change and large U.S. stocks continue to outpace Everything Else. This is certainly possible. Investors in more diversified portfolios would risk getting lower returns…not negative returns but just not returns that would be as good as large U.S. stocks if they continue to perform better than Everything Else. This is always a risk of diversification but, given our research, I believe the risk and return tradeoff today is very much in favor of extensive diversification.

Let’s assume we do think this cycle will shift. If you believe this is likely, getting the exact timing right will be impossible (only with tremendous luck will you get perfect timing). This is not about getting the timing exactly right. Instead this is about the next decade and positioning your portfolio so that you have the wind to your back potentially for many years. This is about thinking long-term and building a portfolio that is best for the long-term…this is how you get the best long-term returns.

My advice: you should have no more than 10% of your total portfolio in large U.S. stocks and the rest in Everything Else. This is proven successful! All investors, those who are low risk or high risk or anywhere in between, will be impacted by these cycles. Get diversified and preferably Super-Diversified! We can help.

Disclosures

Large U.S. Stocks = S&P 500

Bonds = Mid-term U.S. Government Treasuries

Time Periods

  • 1972 – 1979: 12/31/1971 – 9/30/1979
  • 1979 – 1999: 9/30/1979 – 9/30/1999
  • 1999 – 2009: 9/30/1999 – 9/30/2009
  • 2009 – 2019: 9/30/2009 – 9/30/2019

Mutual Fund Assets

  • Large: includes all funds in the following Categories: Large Blend, Large Growth, Large Value
  • As of 9/30/2019 per Steele Database

See our full disclosure for more details.