The Overlooked Challenges of Diversification

FIVE THINGS YOU SHOULD KNOW

1. Equity Markets – finished mixed this week with U.S. stocks (S&P 500) down –0.48% while international stocks (EAFE) rose 1.42%   
2. Fixed Income Markets – were mixed with investment-grade bonds (AGG) losing –0.30% and high yield bonds (JNK) up 0.05% 
3. New Global Trade Power: Mexico? – The ongoing tensions between U.S. and China has led to an unlikely benefactor in Mexico, which has now surpassed China as the biggest supplier of goods to the US. With this shift, the U.S. has become dependent on geopolitical rivals while also being able to source imports from much closer to home. The rest of the globe has also begun ramping up its relationships with Mexico, with foreign direct investment up over 40% in 2023 alone. 
4. Inflation Sentiment Falling – U.S. inflation expectations have now fallen to their lowest levels in over 2 years according to the monthly University of Michigan Survey. Consumers are becoming more optimistic on the economic outlook and should serve as a reference point for policymakers at the Federal Reserve that seek to keep interest rates unchanged for the time being.
5. Key Insight – [VIDEO & ARTICLE] This week we cover some overlooked challenges to being a diversified investor. These challenges can be tough in a given moment, but overcoming them is a big part of finding the path to long-term success. We discuss some of the big ups and downs of one’s likely journey.

INSIGHTS FOR INVESTORS

If you ask most investors, “is being diversified in one’s portfolio important?” I think it’s safe to most would answer “yes.” And we would certainly agree with them, but what does that mean and what if any “downsides” are there to it?

Diversification usually means one of two things practically speaking. First, simply holding more than one position in one’s portfolio to avoid a complete and/or catastrophic loss (think the danger/destruction of all those that had everything in Enron or Worldcom stock back in the day.) The second is the one we’ll be referencing today which is to hold assets and/or asset classes that usually do not react the same way in a given economic environment (e.g. traditionally stocks do well/batter during periods of economic growth while bonds/gold may do well/better during periods of economic struggle).

If everyone believes they should be diversified, why do so many struggle to remain diversified over time?

Below are a few realities that many don’t associate with being a diversified investor that can pose challenges, albeit ones well worth overcoming for most investors.

Challenge 1 – Not Everything in One’s Portfolio is “Working” or “Working as well” all the time

When people think about the “benefits” of diversification they usually start with the protection from certain risks and/or levels of volatility. However, such protection does come with some short-term costs that can challenge investors. One is confusion. You seek diversification so that not everything will act the same way, and yet this reality still catches many investors off-guard. This is particularly true in “risk-on” environments where stocks in general or a particular sector is flying high, and they have to watch bonds or some other segment of their portfolio lag behind. 

The impulse for many is to abandon being diversified to chase returns leading to over-concentration in a certain holding/asset class and risk large drawdowns when the economic tides turn.

Challenge 2 – It Rarely “Feels” Good/Exciting

To embrace being diversified is to embrace patience and discipline. And just like staying/getting in shape, success is more about consistency and daily discipline than the big dramatic changes or actions. 

Furthermore, diversification doesn’t remove volatility or potential setbacks it just reduces them.

The reality then is many investors shift from reduced declines, but declines just the same, to then lagging stocks in bull-markets. Neither feels great or exciting, and yet as we’ll cover below this “tortoise” approach (as in the “tortoise and the hare” fable) helps create a consistency that in our experience dramatically improves an investor’s chances for success.

Challenge 3 – You are invested in things that aren’t in the news and/or discussions with friends

Like point 2 above, while most investors wouldn’t want to admit it, a great temptation to most investors is the “thrill” aspect. It rarely comes up when cooler heads are prevailing and long-term goals are being established, but often springs up when a certain tech stock starts to rip or a crypto-type asset class starts making headlines. 

Bragging about the relative return of one’s market-neutral strategy vs. the Barclay’s Aggregate bond index isn’t going to lead the nightly news or make you the most interesting person at the party, but such distinctions in one’s strategy could well be the difference is achieving one’s goals.

So Why Seek to be Well-Diversified in One’s Approach?

Most people understandably define performance and/or success simply as making money or achieving a goal. And while that is certainly true, there are some other important attributes to “performance” investors should pay attention to that are critical to consistently making money over time and through various market cycles … not to mention life events.

We discuss performance and portfolio design using the acronym L.I.V.E. which stands for Liquidity, Income, Volatility, and Expected Return. While the “E” is well-known and a point of focus, the other “letters” are a big part of the “how” one achieves that success.

Diversification Can Improve Income

Most investors know and frame/filter investments in relation to the S&P 500 stock index. And while some form of those stocks plays an important role for many investors it doesn’t suffice in isolation to help them achieve their goals.

One common goal for investors is definable and consistent income. Yes, those stocks pay dividends but by diversifying into asset classes such as fixed income or real estate many investors can help increase their income stream.

An increase in one’s income planned correctly (see a quality advisor/planner) can help one meet one’s needs without having to liquidate positions in their portfolio, especially during periods of market weakness, thus extending the longevity of one’s money (see also Sequence of Returns Risk).

Diversification Can Reduce Volatility/Drawdowns

While reducing volatility is important for many reasons, one of the biggest is the corresponding reduction of one’s emotional response to their portfolio and potential actions that could accompany excessive emotion/fear.

One of the best pieces put out by our partners is the one you can find in the accompanying link – it will also be the source of the data we include below. The piece by AMG Funds in the clickable link is entitled “Keep Calm and Remain Diversified.”

The piece is full of a lot of fantastic historical stats and events, graphs, and other info that really illustrates the benefits of diversification and the impact it can have on one’s experience as an investor given time.

As the first handful of pages highlight, perhaps most notably pages 13 & 14 covering the topic of Defining Volatility for Clients, volatility is an avoidable part of life for investors.

However, as pages 15 and 16 demonstrate on the topic of The Power of Diversification the “ride”, and I would strongly argue viability of success, is greatly improved with a more diversified approach.  A quick look at their summary boxes shows that in general, a more diversified portfolio versus stocks alone would have historically (1999-2023) given investors: A) 1/3 less volatility, B) 18% less max drawdown, C) much quicker recoveries from most bear markets and D) still almost 90% of the average annual return.

Some may look at the chart and be drawn to the 25-year total growth of $1 million dollars vs. the diversified portfolio. However, as I highlighted above not only would the ride have been smoother for clients and with more income, but while I can’t prove it my experience strongly suggests the diversified investor’s odds of staying the course to see that return are far greater than the stocks alone investor. 

Having been involved with markets since 1995 I’ve seen firsthand and heard countless stories from people about “throwing in the towel” during periods such as the dot.com crash, the 2008 recession or the peak fear in March of 2020. Whether forced out of the market in part or whole because of unexpected events/costs or simply fear, most investors would find it very hard to “do nothing” and stay invested in stocks alone during such volatility.

In Closing

Yes, one could define a diversified investor’s investing life as dull or confusing but isn’t true that most paths to success are defined not by thrills but by consistency, discipline, and patience. 

For overcoming these “challenges” most diversified investors can be rewarded with increased income, lower volatility, lower drawdowns, and quicker recoveries – all while still making a solid return that they are more likely to realize given the reduced “emotional” burden of such an approach.

In short, the thrill here is being able to use one’s time, energy, and emotions for things other than their investments and we strongly believe a greater chance to reach one’s goals.

Have a wonderful weekend,

Tim and the team at TEN Capital

DATA, JUST THE DATA

U.S. Jobless Claims – rose by 3,000 to 220,000 on the week ending September 9^th. This fell below market expectations of 225,000 and holds close to the seven-month low from the previous week.  

U.S. CPI – increased by 3.7% YoY to 307.026 points in August of 2023, which was an acceleration from the 3.2% growth recorded in July. This landed slightly above market expectations of 3.6%. 

U.S. MBA Mortgage Market Index – moved lower 0.8% to 182.20 points in the week ending September 8th, 2023, hitting a new low since December of 1996.  

Eurozone Inflation Rate – held steady at 5.3% in August 2023. This is more than 2.5 times above the ECB goal and higher than the market consensus of 5.1%.