Diversification, Diversification, Diversification

In their well-known and oft-quoted 1986 study of 91 large pension plans, “Determinants of Portfolio Performance,” published in the Financial Analysts Journal, Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower found 94% of portfolio returns were determined by the asset allocation plan and just 6% attributable to market timing and security selection. Interestingly, however, most individual investors spend little time constructing an appropriate asset allocation plan. Rather than determining the ideal percentage to invest in stocks, bonds, and cash and spreading assets among various sub asset classes, most investors look for the hot stock. This return chasing results in portfolios that are overly concentrated in specific stocks or funds, which increases overall risk.

In Are stocks a loser’s bet? another industry influential, William J. Bernstein, quotes research from Dimensional Fund Advisors that found that from 1980 to 2008, the top-performing 25% of stocks were responsible for all the gains in the broad market, as represented by the University of Chicago’s Center for Research in Security Prices (CRSP) database of the U.S. total stock market.  So why not invest in only those carefully chosen “superstocks?”  Bernstein’s answer, “Simple: Because a portfolio of ‘carefully chosen’ equities could easily wind up with none of the best-performing stocks in the market – and thus produce flat or negative returns over many years. Missing out on even a handful of superstocks can leave you short of your target.”

Bernstein notes further that if you missed out entirely on the top 10% performers from 1980 to 2008, you would have cut your annual returns to 6.6% from 10.4%. How does translate into dollars? Bernstein says, “A $100,000 investment in 1980 would have grown to $1.8 million by 2008 at 10.4%. That same amount, at 6.6%, would have grown to only $640,000.” That’s quite a difference.

Here’s the bottom line: It is not worth risking your family’s financial security by speculating on a few stocks, no matter how carefully chose or how much inside insight you think you have. Think of your mother’s advice. “Don’t put all your eggs in one basket.” Spreading your money between stocks, bonds, and cash–asset classes that historically have responded differently to market conditions–is your best defense against being hurt by poor performance in any one asset class. As you see from the Callan Periodic Table of Investment Returns, one asset class never stays at the top or bottom forever. History teaches us that, like a seesaw, as some investments decline, others rise to offset those losses.

Our clients don’t expect us to help them outperform the stock market. Rather, they want our help to develop a plan pay for college, or maintain their lifestyle in retirement, or achieve other important goals. The best way to do this is to invest each client’s money in a globally diversified portfolio based upon their goals and risk tolerance.  This does not mean they will never have losses but it is the best way to ensure they get the market return rather than hoping someone can identify the year’s top stocks for their portfolios.

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