Central banks are setting asset prices, correlations remain stubbornly high, and U.S. equities are outperforming just about everything, causing many investors to ask themselves, “Why did I diversify?” Diversification concerns have been particularly acute for U.S. investors, given the strong performance of equities and bonds in their home market.
“Diversification is the tortoise and concentration is the hare. The tortoise is slow and steady and often wins the race, while the hare takes big leads and then falls behind, rarely winning over the long haul.”
While simple U.S. equity or stock/bond portfolios have outperformed highly diversified portfolios recently, the long-term track record is clear. Highly diversified portfolios have delivered consistently superior returns over decades. In fact, since 1990, $100 million growing at the rate of the average large college and university endowment would have increased to $791 million (9.2% average annual compound return [AACR]) in nominal terms through fiscal June 30, 2013. The same $100 million invested in an undiversified portfolio including 70% U.S. equities and 30% in U.S. bonds would have appreciated to $700 million (8.6% AACR) in nominal terms over the same period—a difference of $91 million! Diversification is the tortoise and concentration is the hare. The tortoise is slow and steady and often wins the race, while the hare takes big leads and then falls behind, rarely winning over the long haul.
In this commentary, we review the rationale for diversification, looking at the historical periods during which simple portfolios dominated. While the history of modern, highly diversified, equity-dominated portfolios is relatively short, our analysis suggests that such periods are transitory and set the stage for diversified investors that stay the course to outperform in subsequent periods. Investors willing to take contrarian positions in cheap assets also tend to benefit as underperforming, undervalued asset classes ultimately recover as the value of assets drives market pricing over the long term.