When the Impossible Happens - A Case for DiversificationSubmitted by Miller Premier Investment Planning, LLC on April 14th, 2016
While the goals of investors may differ quite a bit, one thing is pretty much universal. We invest to increase our wealth. Most people need their portfolio values to increase in order to reach their goals. We need to participate in gains and attempt to avoid losses as much as we can.
The notion of avoiding losses is natural, after all a loss is not only not a gain; it's the complete opposite. Experiencing a loss in our brain is akin to walking east when your destination lies to the west. It makes sense that we want to only purchase assets that make money, and avoid those assets and periods when they lose money. But we sometimes make costly decisions in our effort to achieve better results. We lose sight of the bigger picture and drift off course from our long range battle tested plan. Assuming we have one!
The Costs of Being Wrong
Sometimes the financial markets behave in ways that are completely surprising. Take, for instance, interest rates. Over the past decade there have been many (and I mean many) predictions that interest rates have hit their bottom, and to invest in short-term debt and/or inverse bond instruments (where the price of the security moves in tandem with interest rates). These predictions were promoted by analysts, economists and many investment newsletter services. A few years ago when the 30-year treasury hit 4.0%, the talk was that there was no way it could go lower. Then it did. This same prediction and outcome has been repeated over and over. As a result, many investors have proactively (to avoid losses in bonds) moved to short-term bond instruments to reduce “duration” risk. And they have left a lot of money on the table.
In 2014 alone, Dalbar Inc. reports that the average bond investor earned 1.2% for the year. Doesn’t seem too bad when you consider that cash/savings/money market was yielding next to nothing. But it doesn’t look so good when we look at how the index did that year. The Lehman Aggregate Bond Index returned 6.0% in 2014. Staggering. It’s even worse over the past 30 years. The average bond investor has earned 0.7% per year over the past 30 years while the Index has earned 7.4%. How do investors underperform a passive index so much? Research shows its because they are always moving things around, anticipating what is certain to happen next, and being wrong much of the time. They do things like chasing last year's winners (a losing proposition) or buying last year's dogs (also a losing proposition.) It is like a dog chasing it's tail while getting nowhere.
Who Would Have Thought?
What’s even more surprising is what has happened with interest rates in just the past two years. The Fed had been purchasing billions of dollars of bonds “quantitative easing” since shortly after the financial crisis to drive bond yields down. That stopped a little over a year ago, and they recently have begun to raise rates. So, you have the Fed no longer buying bonds (less demand) and they are raising rates. Logic and basic economics tells us that such actions would result in higher interest rates. But surprisingly that has not been the case. The 10 year treasury bond actually yields less today than it did one year ago, and is almost a percentage point less than it was two years ago when quantitative easing was in place.
And That’s Why We Diversify
These are great examples to the virtue of diversification. Diversification takes the guesswork out of investing. Sure, you may give up the chance to get one right and make a lot of money (hitting a home run,) but empirical evidence shows that we get a lot more wrong (strike out) than we get right, which results in a significant drag on our portfolio performance. And just when everything seems so certain, the market has a way to do the opposite - defying both sound economics and logic. So in our attempt to obtain more gain and reduce our chance for loss, we oftentimes get the exact opposite - less gain and more loss. As behavioral economist, Richard Thaler, is fond of saying, the only sure thing about the financial markets is that they will surprise us. So rather than trying to guess what will do best next and put all of our money in that one basket the best course of action is to stick to a well diversified portfolio built upon a battle tested plan. If you don't have a battle tested plan or your not sure you are properly diversified please feel free to email me at email@example.com with your questions. I have some free easy tools to help determine if you are on track. A wise man once said: "if you don't know where you are going any road will take you there."