Diversification: always having to say sorry #479

by | Jun 21, 2024 | Podcasts

Diversification: always having to say “sorry”

Key Take-aways:

  • Diversification is crucial in investing and prevents over-reliance on any single asset class.
  • The 60-40 portfolio (60% stocks, 40% bonds) has been declared “dead,” multiple times – but continues to be a viable strategy.
  • Investing based on recent performance trends, such as piling into large cap growth stocks, is often a poor strategy.
  • Diversification involves patience and can seem simple – but is not easy to implement effectively.
  • Financial media often promotes short-term trends for entertainment, which can mislead investors into poor decision-making.

Diversification: always having to say “sorry” – Links

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Morningstar article

Morningstar - Returns by Asset Class '01-'23




Diversification: always having to say “sorry” – Transcript

Welcome back to the podcast. This is episode number 479.
I am Tom Mullooly and joining me today is Tim and Brendan Mullooly.

I think we need to talk about diversification.

Why now? It seems like the thing everyone’s talking about these days is large cap growth stocks. I think for good reasons since the market bottom towards the end of 2022, they’ve been a runaway freight train.

In terms of performance relative to your alternatives, like other asset classes out there, stocks, bonds alike, international, small, mid, large. When this happens, whether it’s like it is now with US large cap stocks or with any asset class, when something works for an extended period of time and other areas don’t work, we get sucked into the narrative that it’s the only game in town. If you’re not all in on that one thing that’s working right now, you are a loser in your investment.

Definitely, if you’ve been watching CNBC or reading any sort of national market opinions out there, let’s just buy Nvidia and T bills and let it run. Is the sixty-forty portfolio dead again? Sixty-forty is always dead. One hundred percent and zero percent according to the media. It’s been dead every year since I’ve been doing this.

When you say something like sixty-forty is dead or that US large cap growth or technology is the only game in town, you don’t believe in diversification. I think that will look foolish in the long run as it always has proven to. Throughout 2022, we heard that phrase that sixty-forty is dead. That’s primarily because the Fed was raising interest rates, bonds fell out of bed.

A number of different things killed the sixty-forty portfolio. For the first time in history, bonds didn’t diversify stocks and therefore it was no longer a valid diversifier. I disagree, but okay. It’s pretty hilarious that it took less than twelve months to see headlines again saying maybe the sixty-forty portfolio isn’t dead. It is alive.

2023 was a fine year to have a diversified portfolio of stocks and bonds. In fact, it was such a fine year that now instead of having those discussions of whether bonds diversify stocks, we’re nitpicking the stock side in particular. There are parts of the stock side that are not keeping up with the best performing area of the stock part of most people’s allocation, which is US large cap stocks right now and in particular growth.

This might not be scientific, but it just seems like once those conversations start happening, that’s the wrong time to be making those decisions. If you wanted to go one hundred percent US CAP, you shouldn’t be thinking about that here in June of 2024. You should have been doing it at the bottom in 2022, but no one wanted to do it at that point.

We were talking about the upcoming commodity super cycle that had begun in 2022 at that point. Since then, that hasn’t looked great. To your point, Tim, I think Cliff Asness of AQR has called this momentum investing at value time horizons. Meaning you’re buying what has worked over a multi-year window when in reality if you were going to do anything, it would be the time to fade it.

Or you could be a diversified investor and not need to have opinions about what to pile into and what to fade because it renders it obsolete when you diversify and have exposure to these areas over time in constant and rebalance. I think that is probably one of the hardest parts of being an advisor, trying to wrestle away the idea that we should just do as you said a moment earlier, Nvidia and T bills. That will ultimately wind up, well not ultimately but probably wind up being wrong and maybe very wrong.

I feel like sometimes when you explain our philosophy in terms of diversification, rebalancing, owning a number of different asset classes, it depends on who you’re telling it to but sometimes you just see a look in their face being like that’s it. It’s too simple. Exactly, yeah. Simple but not easy.

It sounds simple and the results are proven over time. But people don’t like it because it involves being patient and being patient is not fun. It’s more fun and more comfortable to just look out the rear view and pile into whatever’s been working most recently.

That’s a terrible investment strategy by all accounts, any way that you measure it over time. I somehow suspect that there’s a lot of people that do that sort of weirdly trend kind of following where they’re actually watching what has worked and just do that. I feel like the financial media has kind of you said the word fun before and I think investing for the long term and fun should not be used in the same sentence.

That’s not what you should describe and investing should be super boring. You need a lot of patience and patience isn’t fun. Don’t use the word fun when you’re talking about investing.

If you’re worried about your investments being not fun enough, you’re probably picking the wrong investments. A good way to feel comfortable and to feel like you’re being smart is to just chase whatever is in vogue right now. It will feel intelligent to pile into what’s worked but you don’t get the results that have already happened.

You get the ones going forward from now until whenever the next trend catches your eye and you’re on to that shiny object. It’s along the same lines, the same or similar kind of conversation when you wake up and say you know what I think we should just sell everything and go to cash. Or you just wanna make allocation changes because you have a feeling about the market.

You may feel good in the moment. You may feel good for five days or five weeks that you did the right thing. But over a longer stretch of time, any longer stretch of time, it’s gonna wind up biting you in the butt.

Even twelve months or one calendar year, which we don’t necessarily think of as long term, things can go from the top performing asset class to the bottom or vice versa. They were an underperformer the year before and then they were the best performing asset class the next year. Trying to figure out when that’s gonna happen is super hard to do.

It’s unnecessary to achieve good term returns. You don’t need to. When we’re talking about investing, we’re talking about asset classes or styles of investing. We’re not talking about individual stocks and we’re talking about diversifying a portfolio.

These areas of the market all serve a role in the portfolio. We can look at the long term historical returns to see that they may be very similar over a multi-decade period but they take a very different path to get there. The part that we complain about in the short term, the variance in those results on a year-to-year basis, is what brings value to these pieces of the portfolio as team members over time.

They complement one another and pick up when one is having the others flowing and vice versa. I think that is a core tenant of diversification. Sometimes when trends remain in place for a couple of years, we have to see this day today or I mean, I don’t know if every investor does.

We do it for a living so we have to look at it every single day. Living through a multi-year period where something underperforms is excruciating in real time. I’m not disputing that but you need to hold what’s happened recently alongside the historical context of what you expect and what made you invest in the first place and think on that before you do anything too rash with investment changes.

These asset classes can change direction pretty quickly. Before most people even realize it. In 2022, we saw commodities at the top of the pile with a positive, I forgot, seventeen percent something like that kind of return overall. In 2023, it was the worst asset class to own.

The time that people actually went in and bought commodities was probably after it had the best year in 2022. They’re not buying that at the beginning of 2022 or the end of 2021 – which is when the performance actually happened in the class. The same goes for the current run-in US large cap tech stocks which got absolutely decimated during the bear market of 2022.

They were the worst performer hands down and they’ve reversed that since then and been the best over ’23 and now halfway through 2024 as well. Looking at those, just like I was saying, twelve months or a year isn’t necessarily long term but just seeing how quickly they can move from the top of the pile to the bottom in terms of performance on a year-to-year basis. You also look at a time period over twenty years, annualized returns of things like large, mid, small, international, emerging markets since two thousand one, they’re all within a percent or two of each other up about six to eight and a half percent annually average per year.

If you give yourself enough time to let these things work and you own them consistently, not trying to jump in or jump out based on what’s worked on a year-to-year basis, you get that averaged annualized return in your own portfolio. It’s hard for people to do that. That’s part of what we have to do as advisors when we go through these periods of time is analyze the portfolio, look at what’s working and of course what isn’t working, and consider within the broader context of what made us make portfolios as they are.

Those laggard areas, are they broken or is there something fundamentally about them that caused us to reconsider them as a viable part of the portfolio? Or are we going through a period of time that might be comparable to a prior one that we’ve just forgotten now because of history? Is this just a normal variance that we should expect over the course of time?

We don’t know. We are making guesses about the future but we need to weigh the historical evidence as much as the recent past even though our brain wants us to do the reverse of that. The danger part for some folks right now as they try to project into the future is they take too short of a period and they say, “Well hey, large cap growth stocks have been returning twelve, thirteen, twenty percent for the last couple of years. If we just use a number of ten or eleven percent into the future, I’m gonna be living on Easy Street.”

I think it’s dangerous to do that if you’re just piling in and then piling out. It’s less dangerous if you are just constantly exposed to that. It’s not to say that US large cap has been crushing it for the last two years now is the time to sell all of your US large cap.

That’s not really what we’re saying. It’s mostly that. How do you happen to test an exposure to it is more so the point of diversification? You kinda tip over into another part of the discussion about timing. Is there a point where you can clearly say, looks to me like the run-in fill in the blank asset classes over let’s get out or let’s you’re making a timing call?

It might not be necessarily based on the performance numbers but more so like do we think this strategy or something about it has, like Brendan you said before, is it broken or does this not, it’s no longer a viable strategy? Less so, we don’t think these returns can withstand another year or two of the same type of things. It’s not to say that you’ll never ever sell out of an asset class completely. It’s more so to say the work needs to be done on the back end and more times than not, the answer is gonna be to do nothing.

It doesn’t mean that that’s never gonna happen. Do the work to continue having the opinion that you should allocate the space and especially do the work when all of the recent performance is suggesting that you should give up. Look into it. Obviously, don’t ignore that. You don’t wanna be stubborn when it comes to allocating but the bar should be incredibly high for giving up on an entire asset class or strategy that had enough evidence to be allocated to in the first place.

That’s important too. If you wanna go blow out of something completely, maybe think back to why you bought it in the first place. What was the fundamental behind doing that? Usually, there’s something to be learned and the something is that your expectation should have been better after onset. Maybe you were excited to be bought it for the wrong reason too. You just bought it because it chart goes up.

You should have appropriate expectations and sometimes the best way to have better expectations is to experience performance that resets those expectations. It doesn’t mean you have to give up on something but it is a good reminder that maybe more work should have been done to understand the strategy to begin with on the way in. It’s easy to buy something that’s currently working because it’s comfortable. Everyone will tell you you’re smart for allocating to it.

You should understand the strategy more than just checking those simple boxes. If that is all that made a good investor then the list of the greats would be a lot longer than it if it was just buy what everyone else says it’s good to buy right now. Before we turn the microphone on, Brendan mentioned this that success is measured from an investment perspective in terms of decades not days.

When you look back to the chart and we’ll link to this in the show notes that Morningstar put together, and Tim you referenced this just a few moments ago, since two thousand one annualized returns by asset classes, they’ve all had their spot at the top of the list. Doesn’t matter if we’re talking about small caps, mid caps, large caps. They’ve each had their turn and so we don’t know from year to year or even quarter to quarter which classes are going to do well and which ones aren’t.

We need to, we meaning the Royal we, just us at this table. Correct and everybody no matter how smart they sound on TV or who you’re speaking with, nobody knows. It’s fine because you don’t have to know to be a good investor over the long term. That’s the point of diversifying and maybe these asset classes all end up a similar place over the long term, but they’re not gonna take the same paths to get there.

If you don’t wanna have to time these decisions, which I think is wise because nobody can do so repeatedly over time in a way that’s additive to performance, then you can find a balance of them that you’re cool with, and rest assured that you’re always going to have the top performer but you’re probably always gonna have the bottom performer too. You’ve diversified. I feel like we dunk on financial TV a lot but in this case, it’s worth repeating that they’re not speaking to you but it doesn’t necessarily mean that you should listen to them.

They’re not gonna be invited back on TV if they don’t sell your small caps to buy all Nvidia. They’re giving us all what we want and what we ask for. They continue to have a spot and the money that comes with selling advertisements on their channel because we all watch. We can’t look away. It’s exciting. We tune in. They’re giving us what we want. It’s not because they’re bad people. They’re doing their job. They’re there to entertain us.

Like I said, entertainment, fun, exciting, those aren’t words that you should associate with a long term investment portfolio in my opinion. Totally. Separate the two. I don’t think it’s fair to use them as a scapegoat and say it’s their fault this happened to me. Take some personal responsibility or work with somebody who does to be able to cut through that. I don’t think these are bad people and it’s not their fault.

It’s not their fault if you or your advisor is very poor at timing the market.

If we were to throw a blanket over this entire discussion, it would be that phrase that we’ve all learned about diversification. Diversification means always having to say I’m sorry about something not exactly working.

In 2022, it was I’m sorry I had US large cap tech stocks.
Since then it’s been I’m glad I did – but I’m sorry I had bonds.  Or I’m sorry I had small caps.

That’s part of diversification. I think that’s a good spot to end.
Thanks again for listening to the podcast. This was episode #479.

Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom and his podcast guest are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions in security discussed in this podcast.

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