Don’t Judge Diversification by Its Short-Term Performance
Thursday, July 30, 2015

By solely looking at the second-quarter data, it’s easy to assume that diversification didn’t work. The average large-cap stock mutual fund ended the quarter flat, while the average mid-cap fund lost 0.2%. Short-term bond funds—both government and general—were also modestly down. High-yield corporate bonds were unchanged. Real estate sector stock funds fell by 9.0%, while long-term government bond funds lost 8.2%.

There were some bright spots in our latest Quarterly Low-Load Mutual Fund Quarterly Update. Health sector funds gained 4.0% and regional/country stock funds gained 3.1%. Overall, however, a large number of mutual fund categories had flat to modestly negative returns.

Over short periods of time, diversification can seem to be nearly non-existent. This is because a low correlation between assets does not mean they will always experience different patterns of return. Rather, low correlations imply that their return streams move mostly independently of each other. To use a different analogy, if you hike the Pacific Crest Trail and I hike the Appalachian Trail, it is possible for us both to head in the same direction at a similar pace at the same time. This is despite the fact that we will end up in very different places.

Over the long term, the data shows that investing in different assets can cause your various allocation buckets to end up in different places. Your equity investments will end up being worth more than your bond allocations, especially over periods of 20 years or more and very likely over periods of 10 years more. (According to the 2015 Ibbotson SBBI Classic Yearbook, bonds have only bested stocks during 12 out of the last 80 rolling 10-year periods. Longer periods favor stocks even more.)

What diversification does give you is a smoother ride. If the higher volatility of stock prices frays your nerves, bonds will provide some cushion even with the current interest rate uncertainty. Diversification also gives you an outlet to do something constructive with your portfolio. Having a bond allocation can give you a source of cash to buy stocks when the equity market goes down. It can also give you a bucket to deploy cash into when your equity allocation gets too large. Diversification's biggest benefit is making it easier to stick with your long-term strategy no matter what type of mood Mr. Market is in.

The downside of diversification is that over shorter periods of time, it may not feel like it is working. It can reduce returns (a compromise for lower volatility). While the math shows improved risk-adjusted returns, many investors focus on whether their account balance is higher or lower than the last time they looked. Plus, over the long term, an all-stock portfolio has delivered better returns. Calculations from Ibbotson show small-cap stocks outperforming during 60 times and large-cap stocks outperforming nine times out of the last 70 20-year rolling periods. Bonds were the top-performing asset class just once. The challenge is sticking with the all-stock portfolio—a feat not everyone can accomplish.

Put another way, don’t be quick to dismiss a diversified portfolio. The oft-referred-to asset allocation strategy of 60% large-cap stocks/40% Treasuries is a tough benchmark to beat. While this strategy does not make sense for everyone—nor does any other specific allocation strategy—the fact that it is a tough benchmark goes to show that over the long term, diversification can provide benefits. You will need patience and discipline to realize those benefits, as well as an understanding that the benefits of diversification may not be apparent over shorter periods of time.

A Change to Yahoo Finance’s Portfolio Tool

An alert to those of you who use Yahoo Finance to track your portfolios: The website is no longer supporting transaction data. As of July 22, users will no longer be able to record the dates of when they made individual purchases or sales of a stock, bond or other holdings. Yahoo says existing transaction data can be copied and pasted into a spreadsheet.

A portfolio tracking tool is available on AAII.com. It can track the performance of stocks, mutual funds, ETFs and preferred stocks.

More on AAII.com

The Week Ahead

More than 90 members of the S&P 500 will report earnings next week. The only Dow Jones industrial average component included in this group is Walt Disney Co. (DIS), which will report on Tuesday.

June personal income and spending, the July PMI manufacturing index, the July ISM manufacturing index and June construction spending will be the week’s first economic reports, with all being released on Monday. Tuesday will feature June factory orders. The July ADP Employment Report, the July ISM non-manufacturing index and June international trade data will be released on Wednesday. Friday will feature July jobs data, including the unemployment rate and the change in nonfarm payrolls.

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AAII Sentiment Survey

Pessimism surged to its highest level in nearly two years in the latest AAII Sentiment Survey. Optimism plunged, while neutral sentiment fell below 40% for the first time since April.

Bullish sentiment, expectations that stock prices will rise over the next six months, plunged by 11.4 percentage points to 21.1%. The drop puts optimism at a seven-week low. This is the 21st consecutive week with bullish sentiment below its historical average of 39.0%, the longest such streak since a 29-week stretch in 1993. Readings below 28.5% are considered to be unusually low.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 3.7 percentage points to 38.2%. This is the first time neutral sentiment has been below 40% since April 2, 2015 (32.6%), ending a record 16-week streak. The decline is not large enough to keep neutral sentiment from staying above its historical average of 31.0% for a 30th consecutive week, however.

Bearish sentiment, expectations that stock prices will fall over the next six months, spiked 15.1 percentage points to 40.7%. Pessimism was last higher on August 22, 2013 (42.9%). The historical average is 30.0%. Readings above 40.1% are considered to be unusually high.

This week’s jump in pessimism is the largest one-week surge since a 26.3-point rise on April 11, 2013. It puts bearish sentiment above 40% for only the fourth time since November 2012. The rise comes as the major stock indexes fell during much of the survey period. This is also the fourth time in eight weeks that bearish sentiment has been above its historical average after spending much of the previous 12 months below 30%.

The link between unusually high levels of pessimism and above-average returns for the S&P 500 index is not as strong as the link between unusually low levels of optimism and higher market returns. For the period of June 24, 1987, through May 7, 2015, the S&P 500 has had a median six-month gain of 5.6% following unusually high bearish sentiment readings. Over the same period, the large-cap index has a median six-month gain of 7.1% following unusually low bullish sentiment readings. These numbers compare to a median six-month gain of 5.3% for all rolling six-month periods over the time span analyzed. For more information, see my May 21 AAII Investor Update, Unusually High Neutral Sentiment Often Followed by Good Returns. (There is no guarantee that history will repeat.)

Causing many AAII members to be cautious are concerns about the possibility of a sizeable decline in stock prices occurring, the pace of economic growth, the lack of wage growth, valuations, the impact of the stronger dollar on earnings and geopolitical events. Keeping some AAII members optimistic is the Federal Reserve’s still-accommodative monetary policy, the ongoing bull market, sustained economic expansion and earnings growth.

This week’s special question asked AAII members how much changes in sentiment toward the stock market impact their portfolio decisions. Approximately 33% said changes in sentiment have no impact and an additional 35% said that sentiment changes have not much or very little impact. Adherence to a long-term investment strategy was the most common reason given as to why. Some respondents said that they focus on other indicators. Slightly more than 17% of all respondents said they consider sentiment when making portfolio decisions, with several saying that they use it as a contrarian indicator.

Here is a sampling of the responses:

  • “I don’t follow changes in sentiment, only my own.”
  • “Little impact to my portfolio decisions as I am a long-term, buy-and-hold investor.”
  • “None. I stick to my plan in good times and bad.”
  • “Not too much when positive, but it helps identify bottoms when extremely negative.”
  • “Large shifts in the AAII surveys get my attention and motivate me to review my portfolio allocations.”


This week’s Sentiment Survey results:

Bullish: 21.1%, down 11.4 points
Neutral: 38.2%, down 3.7 points
Bearish: 40.7%, up 15.1 points

Historical averages:

Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!