Is Diversification Worthwhile?
February 06, 2015

Is Diversification Worthwhile?

Diversification. It’s as good as motherhood, as important as beer, as beneficial as vitamin C and as reassuring as a communion wafer. Investment professionals swear by it. Academics applaud it. Financial planners demand it.

Let’s face it: Everyone loves investment diversification. Unlike almost anything else in the known universe, diversification is an idea that has no enemies.

The only problem is that it isn’t treating investors well. In 2014, according to Morningstar, the average world allocation fund provided a return of 1.54 percent. A world allocation fund is free to invest anywhere in the world. It can buy stocks or bonds in emerging markets. It can go where no man has gone before, just like Star Trek, if only the place has an investible market. These are funds that are supposed to find opportunity and safety somewhere, no matter where it is.

And what did they find? 1.54 percent. That’s almost comical. Except it involves billions of dollars of real money for real people and real retirements.

Meanwhile, what did the average moderate allocation fund do? These funds invest in domestic stocks and bonds. Some call them balanced funds. Whatever you call them, they never leave home. They are brown wrens. The world allocation funds are global peacocks.

Well, those dull little things provided an average return of 6.21 percent last year.

Can it get worse? Of course it can. Diversification didn’t pay off in 2013, either. The score: moderate allocation fundsm 16.48 percent; world allocation funds, 10.07 percent.

The stay-at-home funds also beat world allocation funds in 2012 (11.72 percent vs. 10.75 percent), 2011 (minus 0.11 percent vs. minus 3.99 percent) and 2010 (11.83 percent vs. 10.58 percent).

Over the last five years (2010 through 2014) the average moderate allocation fund provided an annualized return of 11.18 percent. The average world allocation fund provided an annualized return of 9.10 percent. That’s an impressive 2.08 percent annualized advantage for the brown wrens.

Today, diversification may not be dead, but there are lots of people ready to kill it. In a world of what-have-you-done-for-me-lately investors, we can expect no kind words for diversification.

But a longer view shows diversification still counts.

Here’s the reality. Diversification was irrelevant during the financial crisis, 2008 and 2009. It didn’t matter where you invested your money. Everything crashed in 2008.  Everything soared in 2009. If we round down to full percentage points, both category averages fell 28 percent in 2008 and rose 24 percent in 2009.

But before the crash, diversification worked. Managers found opportunities. Stocks in other countries provided better returns. In 2004, 2005, 2006 and 2007, the average world allocation fund beat the average moderate allocation fund. Over the last 10 years the average world allocation fund provided an annualized return of 8.24 percent. Moderate allocation funds returned 5.93 percent over the same period. So world allocation funds had an annualized advantage, over 10 years, of 2.31 percent.

Think about it.  The performance of the average world allocation fund was good enough between 2005 and 2007 to overcome the disadvantage of 2010 through 2014.

Nor is that the end of history. The average world allocation fund provided an annualized return of 5.17 percent over the last 15 years. The average moderate allocation fund provided an annualized return of 5.07 percent. That’s a tiny difference---only 0.10 percent a year--- but it still favors broad diversification.

Now let’s ask another question. How about finding a fund whose manager knows when to invest in US stocks and bonds and when to invest in other markets? That’s a neat idea.

Lots of people talk about doing this. But it’s just talk. You can find some evidence in the performance of the world allocation funds over the last 5 years. Remember, they are the ones free to invest anywhere in the world. So they could have moved money from overseas to US investments during that time.

Did they?

No way. Here’s the evidence. The average moderate allocation fund returned an annualized 11.18 percent over the last 5 years. Were any world allocation managers smart enough to beat that figure? Just barely. Two funds beat the moderate allocation average. They did it by tiny amounts. So they were exceptional, but marginal. So much for smooth moves.

Bottom line. Diversify. Just don’t expect the world.

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.