The Guardrails of Diversification
Given the fact that SMI includes "Diversifying for Safety" as a major emphasis in our Four Levels framework, you'd be correct in assuming that we consider diversification an extremely important subject. Over the years, this Level Four column has explored many different specific ways to diversify a portfolio through the addition of particular products or strategies. This month, instead of looking at a specific diversification tool, we're going to take a broader view and discuss the bigger picture of why diversification is necessary.
This chart is a variation of what is often called the "Periodic Table of Investment Returns." We've modified it to include only the five major stock risk categories tracked in SMI. The columns show the returns for each risk category for a particular year, with the best performing group at the top and the worst at the bottom. For example, the first column shows the returns from 1997. The average small/value fund tracked by Morningstar gained 29.5% that year. Each square below that shows the returns of another risk category until you finally reach the foreign funds, which gained just 7.2% in 1997.
The layout of this table is particularly helpful for tracking how specific market segments fared relative to each other over several years. The shading of the boxes helps you to visually track a particular category from year to year. Without exception, each market segment has gone through years of strength and years of weakness relative to the other categories. Each of the five categories spent at least one year as the poorest performer, and each also spent at least one year at the top, with the exception of large/value funds which finished second four times in ten years.
The chart vividly illustrates how the relative performance of particular market segments can be quite volatile from one year to the next. A good example is the relative performance of the small/value and foreign categories. In 1997, small/value was the place to be, with the average fund racking up a 29.5% gain. That was more than 20 percentage points better than the average foreign fund, the worst performing category that year. In 1998, the tables turned, with foreign in the second best position, roughly 19 percentage points ahead of small/value, that year's worst performer. In 1999, foreign funds crushed small/value funds again, this time by a whopping 45%-6% margin. But by 2000 another reversal had taken place, vaulting small/value to a 32 percentage point advantage over foreign, which had dropped into last place.
Taken together, the average foreign fund exploded for a 64% gain* in 1998-99, two years when small/value didn't even break even. But lest you feel too sorry for small/value investors, their cumulative gain in 1997 and 2000 was 54%,* while foreign investors lost 7%. For that four year period as a whole, the average foreign fund racked up a total gain of 52.2%,* while the average small/value fund gained 53.2%.* Only 1% separated their overall returns, yet the table illustrates the varying rags to riches paths each took to get there. (*After compounding is taken into account.)
Some might look at an example like this and conclude that it really doesn't matter which categories you invest in because they all go through their ups and downs. While there's an element of truth to that, it ignores the psychological impact of watching your funds struggle to gain 6% one year when another part of the market is racing up 45% (1999), or losing 13% rather than gaining 19% (2000). Too many investors, seeing a huge disparity between their results and another market segment, start chasing the hot areas. This leads to a never-ending game of catch-up, always trailing the market average as a result of jumping from one sector to another just as they're about to cool off. Very few people can tune out the market and ride through the volatile ups and downs that come with being heavily invested in a single, narrow slice of the market.
The far better path for most investors is to spread their money across all of the primary market segments. Yes, this ensures your overall portfolio result will always trail the returns of that year's hottest performers. But it also ensures you'll always participate to some degree in each year's hot area too. This "spreading your risk" mentality is the essence of diversification, and its real beauty is seen in the fact that it produces returns similar to the individual risk categories while smoothing out an incredible amount of volatility along the way. By muting the sharp ups and downs in your portfolio's performance, you protect yourself against the most dangerous obstacle an individual investor faces—your own emotions. Slow and steady doesn't just win the race, it keeps you in the race. As we've said before, the key to long-term investing success isn't timing the market, it's time in the market.
So the next time you wonder if it's really necessary to own funds in all five SMI risk categories, or are tempted to throw caution to the wind and load up on a particular investment type, remember the periodic table of investment returns and the diversification lessons it holds. It's said that fear and greed drive the markets, and sadly that's often the case. As an individual, your goal should be to eliminate fear and greed from your investment life. They're the twin ditches on either side of the road that threaten to wreck your investment journey. Thankfully, a handy set of guardrails labeled "diversification" is available to every investor. Secure those guardrails first and you're much more likely to enjoy your investment ride. 
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