Not Improbable, but Probably Unlikely

As readers of this blog well know, I am a fan of diversification and long term strategic investing. Though Q4 last year showed some significant “catch-up” from previously underperforming asset classes like emerging market equities and real estate investment trusts (REITs), there is still a lot of catch-up to be done. The thought leaders at Research Affiliates, led by Rob Arnott, recently published a paper titled “Is Diversification Dead” (here) on this very topic. Their conclusions are telling.

The authors start by identifying the three main groups of asset classes: core equities, core bonds, and diversifiers. Core equities include the S&P 500, small cap equities, and international developed markets; core bonds include U.S. Treasuries and investment grade corporates. Diversifiers are a more disparate group including inflation-protected bonds, high yield and emerging market bonds, emerging market equities, and commodities.

A historical review of these three main groups of assets showed that diversification worked comparably very well since 1975 but has lagged significantly over the past 10 years. In fact, some are calling the 2010’s the “lost decade of diversification” because of the relatively weak performance of the diversifying asset classes.

The authors showed that over the past 47 years a core 60/40 portfolio (60% S&P 500 and 40% Barclays Aggregate bond) generated an annualized return of 10.4% compared to an equal-weighted fully-diversified portfolio annualized return of 10.9%. The results during the decade of the 2010’s, however, showed the 60/40 portfolio with a 9.2% annualized return compared to only 6.4% for the equal-weighted fully diversified portfolio; an underperformance “cost of diversification” equal to 2.8% annualized! The results are worse if you extend the 2010’s to include 2020!

The authors then tried to explain the cause of the underperformance of diversification and identify where we might go from here. The single most important determinant was the expansion of S&P 500 stock valuations with markets reaching record heights that the diversifiers could not keep pace. In fact, for this trend to continue the S&P 500 would need to see valuations continue to grow by 40% from here; something that is not improbable, but probably unlikely!

So, not surprisingly, the authors make a strong case supporting the academic work in favor of diversification despite the recent decade of underperformance relative to a 60/40 portfolio. In closing, they say words that I echo per my blog post from January 3 (here) :

Can we really count on another round of speculative good fortune—indeed, to trust that continued escalation in valuations will successfully serve trillions in future pension obligations? If not, now is not the time to abandon diversification and diversifying asset classes. Certainly, if mean reversion does occur, heeding the lessons of the 2000s we must acknowledge that diversification is needed today more than ever.