It Still Works
After the Great Recession, a friend asked me if diversification still made sense. He followed up with another question before I could answer. He asked, “If my assets are diversified, how come I’m losing money?” I said diversification still works, but it doesn’t protect you against a loss. Diversification helps reduce your risk allowing you to create generational wealth.
During the Great Recession, bonds outperformed stocks, but stocks have topped bonds for the past ten years as the market rebounded from the recession lows. This year, so far, bonds are winning. Investing is not a binary event. Few investors allocate 100% of their assets to bonds or stocks and flip between the two depending on their temperament
Stocks can decline, especially after a 10-year bull market. Stocks enter correction territory about every three to five years. Over the past two decades, the market has realized drops of 30%, 40%, and 50%. The average decline for the past twenty years has been 9.3%. The market is always correcting, always adjusting, so it should not surprise you when it falls.
Microsoft, Apple, Amazon, Facebook, Alphabet, and Netflix account for 21% of the S&P 500 Index and 48% of the NASDAQ 100. These super six companies generated an average total return of 280% for the past five years compared to a 39% return for the S&P 500. However, they have experienced periods of underperformance relative to diversified portfolios. Microsoft fell 71% from January 2000 to March 2009, and it took 17 years for it to reclaim its previous high. Apple fell 75% in 1985, 74% in 1998, and 80% in 2003. Amazon fell 93% during the Tech Wreck. And risk arrives quickly – like lightning. Last year Hilton, Hertz, and Southwest Airlines were up, on average, 33%. This year, as a group, they’re down 56%, and Hertz is contemplating bankruptcy.
Stocks, bonds, and cash are components we use to build diversified portfolios. Stocks for growth, bonds for income, and cash for safety. Stocks are subdivided into large, small, and international companies. Bond maturities vary between a few months to several years.
A diversified portfolio has many moving parts, and depending on the market cycle; some are up while others are down. One goal of a balanced account is to keep people invested for the long-term, despite the roller coaster ride of the market. Dimensional Fund’s 60% stock and 40% bond portfolio is down 10.5% for the year. It has averaged 7.5% for the past twenty years, and it has risen 75% of the time. Since 1926 it has been profitable 78% of the time and generated an average annual return of 8.9%.
How do you develop a diversified portfolio? It starts with your financial plan. Your plan will incorporate your hopes, dreams, and fears. It will integrate essential financial components to determine your risk tolerance and asset allocation. If your investments are aligned to your goals, you’re more likely to remain invested so you can capture the long-term trends from the market. A balanced account is designed to withstand several market conditions and endure for generations. Diversification still works because we don’t know in advance which investments will perform well. Therefore, a globally diversified portfolio of mutual funds is the best way for most people to invest. If you want to invest in individual stocks or concentrate your investments, do so in a taxable account so you can take advantage of the tax code.
As we continue to deal with uncertainty from the virus and rumble through a volatile market, focus on your goals, create a plan, think long-term, and good things will happen.
But divide your investments among many places, for you do not know what risks might lie ahead. ~ Ecclesiastes 11:2
May 7, 2020
Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets.
Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and are not suitable for every investor.