Diversification has gotten a bad rap as of late. Over the last five years, due to the strong performance of US equities, a simple 60% US Stock / 40% US Bond portfolio would have been one of the best portfolio allocations—outperforming the majority of more diversified asset mixes, especially anything including an allocation to international stocks.
Increasing correlations between asset classes are often cited by those claiming that diversification is no longer helpful. That, coupled with the US market’s recent outperformance means many are questioning the need of going beyond this simple 60/40 portfolio.
The problem with this logic, though, is that what’s worked best recently won’t necessarily work best going forward—investing isn’t that easy. For several reasons, which we are about to see, building a diversified portfolio allocation may be more important now than ever.
From a valuation perspective, there is solid rationale why we shouldn’t expect a US 60/40 portfolio to continue to outperform. US stocks are more expensive than many of their global counterparts and bond yields are low.
Larry Swedroe, writing for ETF.com, outlines a simple, forward-looking real (after inflation) return model for US and International equities. Based on current valuations, he estimates forward annualized real returns of 4.1% for the S&P 500, 7.4% for International Developed markets and 8.0% for Emerging Markets.
And Research Affiliates, in a recent report, paint an even worse picture for the simple 60/40 over the next decade. They conclude that “the ubiquitous 60/40 U.S. portfolio has a 0% probability of achieving a 5% or greater annualized real return” over the next ten years. And on their asset allocation website, they come up with a similar forecasted return premium as Swedroe for International stocks versus the US stocks.
Additionally, while short-term correlations are rising, this overlooks the fact that markets move in cycles over longer periods. Swedroe, in the same ETF.com article we looked at before, points out that from 2008-2016 the S&P 500 was certainly one of the best places to be invested—returning 6.9% per year compared to -0.3% for Foreign Developed Stocks and -1.2% per year for Emerging Market stocks. However, over the seven years prior, from 2001 through 2007, The S&P 500 index returned 3.3% per year—much less than Foreign developed stocks at 8.8% per year, and Emerging Market stocks at 24.0% per year.
But, even for anyone discounting the cyclical nature of markets and current valuations for US stocks and bonds, there remain additional compelling reasons for building a diversified portfolio—especially for anyone close to retirement, or already retired and spending down their portfolio.
A “diversified” portfolio has faced smaller drawdowns and quicker recoveries compared to the less diversified 60/40 portfolio. Using data from the very useful Portfolio Charts website, we see that the simple 60/40 portfolio has experienced a maximum loss of 36% and, in the worst case, taken just over ten years to recover this loss. However, a more diversified portfolio would have had a drawdown of “only” 29% (almost 20% less than the 60/40 portfolio) and a maximum time to recovery of 5 years versus 10 years for the 60/40 portfolio.
For anyone nearing retirement, and therefore nearing the end of the capital accumulation phase of life, reducing the magnitude and duration of losses is crucial. Not only does it matter from a capital preservation and return compounding perspective, but also it’s critical from a behavior perspective. In their book Adaptive Asset Allocation Butler, Philbrick, and Gordillo write the following:
However, data on investor behavior suggest that this investor is unlikely to stick with a strategy for much longer than four or five years. From Dalbar’s 2014 Quantitative Analysis of Investor Behavior Report, we know that investors in stock and bond mutual funds tend to stick with their strategy for about three years, while diversified investors have historically held on for almost five years.
Going through a 10-year period with your portfolio underwater, like the 60/40 portfolio has experienced, is, needless to say, going to make it hard to stick with this strategy over time.
But, perhaps the biggest benefit to building a diversified portfolio is an increased safe withdrawal rate—meaning additional spending in retirement.
Again, using data from the Portfolio Charts website, and comparing our “diversified” portfolio to the 60/40 portfolio we see that our safe withdrawal rate over a 30-year retirement increases from 4.4% to a little over 5.8%. This means, on a $1 million portfolio, an increase in “safe” spending of 32%, from $44k to $58k. (Click on any chart to enlarge)
And, even making the simple change of moving from the 60/40 US portfolio to one that holds a mix of International stocks and US stocks has benefits. Despite a minimal change in the compounded annual returns of these portfolios since 1972, because of the added diversification, the withdrawal rate increases from 4.4% to 4.8%—A nearly 10% increase in retirement spending simply by diversifying internationally.
So, despite the bad rap diversification has received recently, don’t forget about its benefits. Investing is hard because what’s worked best recently, probably isn’t going to work best going forward. The fact that building, or maintaining, a diversified portfolio might not feel great right now is one excellent reason to do it. And for the reasons we’ve just outlined, it’s likely that building a diversified portfolio is more important now than ever.
With an acknowledged healthy standard deviation around the estimates
Add inflation to get the more commonly used nominal returns. For example, if inflation is 3%, the nominal forecasted return on the S&P 500 is 7.1%.
We are using US Large, Small and Value Stocks; International Broad, Value and Emerging Markets stocks; Commodities; Real Estate; and Bonds in this example to represent the “diversified” portfolio.
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