To Diversify Or Not?
To Diversify…….or Not?
Most investors are under-diversified. They do not own commodities or real estate even though those categories are mostly non-correlated with the stock & bond markets and represent about 40% of global investable assets. It is easy, and sometimes more comfortable, for under-diversified investors to over-invest in domestic company stocks (especially local & familiar stocks).
Doing so may make them feel safe, however, this can leave them exposed to greater volatility in their investment returns. (source: handbook of the Economics of Finance, 2013)
There are seven core asset classes:
- U.S. Stocks
- U.S. Bonds
- Non U.S. Stocks
- Non U.S. Bonds
- Real Estate
- Commodities
- Cash/Cash Equivalents (such as CD’s, treasury bills and money markets)
And twelve underlying sub-categories:
- U.S. Stocks (large, mid-size & small)
- Non U.S. Stocks (developed & emerging markets)
- Real Estate (REITS)
- Commodities (natural resources & commodities)
- U.S. Bonds (aggregate bonds & TIPS)
- Non U.S. Bonds (international bonds)
- Cash (money markets)
If you were to equally weight 8.3% in each of the 12 sub-categories, over the last 20 years (through 12/31/23), you would have gross investment returns of about 6.5% / year.
U.S. Stocks (large, mid & small) averaged 9.7% over that same time period, and came in first place out of all the asset categories, while commodities were basically flat (-.13%) for that same 20-year period. (source: 7Twelve Advisors.com)
Wealthier clients, those with 1MM (one million) or more of investment net worth, have access to private markets (i.e. those that are not publicly traded), in the areas of real estate, equity and debt. Those have typically performed above the averages of traditional investments (stocks, bonds, mutual funds & REITS), but carry with those returns higher risk.
In conclusion, financial advisors will most of the time tend to diversify, and sometimes over-diversify, but should always be focused on their clients objectives, risk tolerance, and time horizon. Under-diversification only makes sense if you are “lucky” enough to pick the right asset categories year after year.
Diversification is the more prudent approach for most investors, even if overall returns may be lower, they are more predictable. Which is really what most people want during their retirement years.
Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Diversification and asset allocation strategies do not assure profit or protect against loss. Past performance is no guarantee of future results.