Last month saw a potential short-term top in commodities prices, as both oil and gold prices seem to have stalled from their upward march in 2008. That should have spelled relief for the stock market, which has been down by over 12% (at the time of this writing) for 2008, as measured by the Dow Jones Industrial Average. Yet, it didn’t.
These recent trading days saw the Dow swing back and forth by many hundred points. The market may be waiting until after Labor Day or the political conventions, when it can have another few weeks to discern that commodity prices have stopped their recent surge. In the meantime, Americans will be back from their summer vacations and “idle” time; historically, that leads to more investment activity on Wall Street.
When those investors do shake the sand out of their shoes and take a closer look at how their investments are doing, the advice here is to focus on diversification – spreading your investments around various investment classes to reduce overall portfolio volatility.
Avoiding The Extremes
During uncertain times, a common mistake I often see our clients make, is wanting to get rid of the manager or asset class that recently performed the poorest, and invest in last year’s best performer. Or, they want to hide in the bushes with TIPS, CDs, bonds and cash-like investments. I believe this is exactly the wrong strategy. These investments are paying a pittance, and by the time you get them redeployed, you will likely miss some of the potentially-best up-trading days that are typical after a bear market.
Instead, this should be the time to focus on buying and positioning yourself in better-priced investments than when the Dow was at 14,000 less than a year ago. A very wise investment manager once taught me an important lesson that is a cornerstone of my investment beliefs: “Avoid the crowds at extremes.” My job is easy when the market surges upward – clients fight through the door to get invested at any price. But when it’s the better value to buy, these same investors are jumping out of windows. They are overreacting when they should be looking at their portfolios to make sure they’re well-diversified.
Diversification simply means dividing your investments up into more than one uniform category. It’s one of the better ways, if not the best way, to help protect your money from the pendulum swings of the economy and the financial markets. By diversifying your investments, you’re lessening the risk that one investment that has gone sour will poison the rest of your portfolio.
A Closer Look at Diversification
To illustrate my point, the “20 Year Periodic Table of Returns” chart provided by our friends at Ibbotson and BlackRock, shows annual total returns of selected indices and Lipper Averages in order of performance, for each year, for the last 20 years ending 2007.
We are going to focus on the 5 best and worst performing indices and averages for the last 5 years, as reported on the Periodic Table of Returns:
| Year | Best Performing | Worst Performing | Difference |
|---|---|---|---|
| 2007 | Russell 1000 Growth +11.81% | Russell 2000 Value -9.78% | 21.59% |
| 2006 | MSCIEAFE(International) +26.34% | Russell 1000 Growth +9.07% | 17.27% |
| 2005 | MSCIEAFE(International) +13.54% | Russell 2000 Growth +4.15% | 9.39% |
| 2004 | Russell 2000 Value +22.25% | Russell 1000 Growth +6.30% | 15.95% |
| 2003 | Russell 2000 Growth +48.54% | S&P 500 +28.68% | 19.86% |
Click here to access all 20 years of data plus index descriptions.
As you can see, the average difference between the best and worst performing indices, for each year over this 5-year time frame, was a whopping 16.81%! So, as an investor, by not being diversified, you may have given up some sizable returns by unfortunately being invested in the worst performers. What this shows is that trying to pick the best asset class for the current or future years is very difficult, if not impossible. A more-realistic scenario is to target somewhere in the middle.
WrapManager is adept at recommending the asset allocation and money managers for your particular needs, but realistically, we will not be able to keep your investments in the “top” every single year. The good news however, is that by applying WrapManager’s Power of Diversity principles, we strive to not keep you in the “bottom” either.
The Big Picture
When you begin to look at the issue of diversification, one fact becomes clear: you’ve begun to look at your portfolio as a whole, rather than as a series of disparate investments, shoe-horned into your portfolio like your extended family at the dining room table on Thanksgiving Day.
This is a good thing. Why? Because looking at your portfolio as a whole is what you should do when you’re making investment decisions. Yes, it could be tough to pass up investing more in last year’s best performing money manager or asset class, but what if you already have heavy exposure in the International asset class or money manager invested there? You may want to look at the asset class or money manager that is undervalued or discounted.
With diversification, you can still have international exposure (if it’s appropriate for you) by adding it to your portfolio, and balance that with another asset class like large cap value. That way, you will be better-positioned if the dollar starts to appreciate and the international asset class goes into a death spiral, bringing those allocated investments with it.
A Diversification Strategy
Overall, your investment portfolio should be diversified into prime asset classes such as stocks, bonds, cash and money market-type investments. Additionally, you should be diversifying within those categories. In the stock portion of your multi-manager managed account, you should have a blend of large-, mid- and small-cap money managers. A few of those managers should lean toward growth, others toward value. For our clients that are adding new money to their managed accounts, when appropriate, we are currently suggesting a small-to-mid cap growth and large cap deep value manager focus.
The fixed income portion of your portfolio should be diversified, too. Bonds, money market funds and certificates of deposit are all attractive candidates for your portfolio. These should be invested with varying maturities, credit quality and liquidity features.
Better yet, let us review your asset allocation to make sure you are properly allocated for your peace of mind.
The Power of Diversity
At WrapManager, we believe diversity is a formidable force in the world of private wealth management. Such diversity can be seen in the numerous choices investors have today, including WrapManager’s selection of hand-picked money managers with distinct and diverse investment styles. This is WrapManager’s investment philosophy, and we call it The Power of Diversity.
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