Has Diversification Stopped Working?

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Arleen Hudson
5 years ago
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We will try to address some of the more timely and relevant questions that investors, executives, and retirees

1 Questions from the Field: During the course of teaching seminars, writing articles and newsletters, and meeting with clients we hear lots of questions. We will try to address some of the more timely and relevant questions that investors, executives, and retirees are asking us. Our question(s) for this month are: Q: Has diversification stopped working? (and why does my portfolio not act like the US stock market?) Carl Richards Behavior Gap

2 Page 2 Q: Has diversification stopped working? (And why does my portfolio not act like the US stock market?) The last 24 months have been unusual and difficult for a broadly diversified portfolio approach. What has worked very well over long periods of time, has struggled since early Diversification has hurt portfolio returns rather than helped them, as the only investment category that has done well over that span are US stocks and in 2014, only large US stocks. Looking at the table below of YTD returns by asset class, you can see that in 2014 US large stocks (Dow Jones, and SP 500) did great, US small stocks (Russell 2000) are only up a little for the year (and were until recently in negative territory), international stocks (MSCI EAFE and Emerging), were negative, and gold and energy were way down (they were the best performers for the first half of 2014.) Diversification has hurt portfolios this year and last. Table 1: 2014 Asset Class Returns *Investors cannot invest directly in an index 2014 has ended up being a carbon copy of 2013 as any attempt to be widely diversified has resulted in a big performance gap as measured against US large stocks only. The question for all of us is this an anomaly? Or will this continue indefinitely? You can see from the graph below that the decade prior to 2013 looked quite a bit different than what we have recently experienced the last two years, and that US stocks were OK but not great over that time period. The last time I can recall that US large stocks over performed every other asset class by such a large margin was in the late 1990 s, right before the crash of

Page 3 (US stocks had below average returns for the ten year period prior to 2013) *www.stockcharts.

3 Page 3 (US stocks had below average returns for the ten year period prior to 2013) * A broadly diversified approach has worked quite well for investors over the long haul, and has been a time-tested approach. An investor who kept most of his money in US Stocks had much lower returns this century until just the last two years. The US stock market as measured by the SP 500, earned an annualized return of only a measly 0.54% per year from the start of the century until Dec. 31 st 2011 an 11 year period where US large stock returns were almost non-existent. (Source: Morningstar) Here is another example from US Large Stocks were the worst performing of the stock asset classes during that period, and only earned about 1% per year during that time.

4 Page 4 If an investor was not diversified over that longer period of time, they might have missed out on better returns in other areas of the investment markets.

5 Page 5 The Strengthening USD and the Impact on Investments Another issue to watch and understand is the surprising move that the US Dollar has made since early summer. The USD has steadily and dramatically dropped in value (relative to other currencies) since the beginning of the century, and had lost about 40% of its purchasing power relative to other currencies over that time. However, there has been a reversal of that trend over the last few months, and the dollar has made a short and steep strengthening move. ( size=m&log=0&t=line&v=1&g=1&evnt=1&late=1&o1=&o2=&o3=&sh=100&indicators=&addindicator=&submitte d=1&fpage=&txtdate=#jump) What does that mean to investors and why is it important? A stronger dollar tends to depress commodity and gold prices, and acts as a headwind to international stock prices. Since about 2000, the prevailing trend of a weakening USD has allowed us to enjoy above average returns in precious metals and commodities and perhaps especially in international stocks. You can see an example of that in the chart below. Note that the best performing asset classes for the first half of 2014 and then compare it to Table 1 above and you can see how the upward move in the USD since July 2014 has worked against international stocks, gold and commodities.

Page 6 (Asset Class returns for the first half of 2014) *Investors cannot invest directly in an index One important thing to note it may be that the USD is NOT getting stronger, but rather that other

6 Page 6 (Asset Class returns for the first half of 2014) *Investors cannot invest directly in an index One important thing to note it may be that the USD is NOT getting stronger, but rather that other countries are weakening their currencies. Warren Buffet was asked what he thought about the USD, and replied that, The US Dollar is the worst of all the world s major currencies except for the rest of them. Many of the world s major countries are actively weakening their currencies. China, Japan, most of Europe through the Euro, and surprisingly even Switzerland. Why are they doing this? To try and protect their export business and balance of trade. This currency manipulation by the nations may be the major contributing factor to making the USD stronger in recent months. The question for investors is is this recent several month spike in the USD a permanent U turn from the last 14 year s weakening trend? Or is just a blip, and will the USD continue weakening? Diversification helps us to deal with uncertainties like this. We might like our portfolio s to be positioned to try and take advantage of either scenario.

Page 7 Carl Richards Behavior Gap Large US Stocks Compared to Smaller US Stocks Another area where market returns had large discrepancies in 2014 was large versus smaller company stock.

7 Page 7 Carl Richards Behavior Gap Large US Stocks Compared to Smaller US Stocks Another area where market returns had large discrepancies in 2014 was large versus smaller company stock. Smaller companies in 2014 in general were barely positive for the year, as contrasted to larger US stocks which earned double or triple the return. (Please see Table 1 above.) Do larger stocks always earn a higher return than smaller companies? Quite the contrary. Smaller companies have often and over the long haul had a far higher return, as can be seen from the graph below.

Page 8 US Stock Market Returns from Largest to Smallest 1927-2010 Source: Eugene Fama & Kenneth French, University of Chicago That was not the case however in 2014, and an allocation to small

8 Page 8 US Stock Market Returns from Largest to Smallest Source: Eugene Fama & Kenneth French, University of Chicago That was not the case however in 2014, and an allocation to small companies hurt rather than helped an investor. Should we abandon smaller stocks in our allocations? History tells us that could be a mistake regardless of what happened in Why did larger US stocks do so much better last year? One possibility is QE and Money Printing The United State unleashed a money printing scheme in that is unprecedented in our history. We printed about 1.5 Trillion dollars during that period. To put that into perspective, the total amount of money created in our country only totaled $800 billion from in two years we printed double the amount of money then was created in the entire last century! Keep in mind that no one, not the folks at the Fed, the US Treasury, or any economist or government official, has any historical guide or idea how this will all end or what the possible consequences might be.

Page 9 This has not happened before. The amount of money the Fed is creating. So, there s just this incredible science experiment, and no one really knows where this goes and how it goes.

9 Page 9 This has not happened before. The amount of money the Fed is creating. So, there s just this incredible science experiment, and no one really knows where this goes and how it goes. But I m not convinced, over the next three or four years, that we know how this thing is going to turn out. I tell everyone we re in this giant science experiment and we re the mice, unfortunately. Mike Kerr Capital Guardian Group What we do know is that QE/money printing seems to be helping US stock prices so far, and perhaps disproportionately helping larger US stocks more than any other group. What to Do? Investors need to ask themselves have the laws of diversification really been revoked? Should we ignore time-tested principles of investing success?

10 Page 10 Remember that the last time that it seemed like the laws of diversification were suspended was in the late 1990 s. Everyone clamored to be in large US growth stocks and for a short time that move was rewarded. However, the next decade the US stock market as a whole struggled with many years of subpar returns while some of the sectors like smaller companies and value stocks did quite well. Maintaining a long term discipline of diversification has rewarded the patient investor and sometimes punished the impatient and imprudent. King Solomon, who had a reputation as the wisest man, encouraged us to: Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth. Investors may also want to review their portfolio holdings in light of the possibility that the USD continues an upwards trend, and evaluate what their investment exposure is to a strong USD. And, unusual times like the period we are in now are a great opportunity to review and understand what the level of risk is in our portfolios, and to project and plan for liquidity and income needs from our investments. Our next client letter will examine risk planning in more detail. We can review this at our next meeting, and of course we are available for your calls. With hopes for a successful and prosperous Warm Regards, William R. Gevers Financial Advisor PS: We have been repeatedly asked by clients if they could share these notes with their friends or neighbors. Please feel free to forward this with the stipulation that it may only be forwarded if done so in its entirety with no portions omitted. We would be delighted to share our comments and opinions with your friends, and welcome your comments and feedback. If you received this and would like to be included on our newsletter list, please us at info@geverswealth.com Copyright 2015 William R. Gevers. All rights reserved.

11 Page st Place SE Suite 102 Issaquah, WA98027 Office: Fax: The views are those of, and should not be construed as individual investment advice. All information is believed to be from reliable sources; however, no representation is made as to its completeness or accuracy. All economic and performance information is historical and not indicative of future results. Investors cannot invest directly in an index. Please consult your financial advisor for more information. Securities and advisory services offered through Cetera Advisor Networks LLC Member FINRA/SIPC. Cetera is under separate ownership from an any other named entity.

Page 12 US Money Supply, US Dollar, and Inflation/Deflation Watch "Neither a wise man nor a brave man lies down on the tracks of history to wait for the train

12 Page 12 US Money Supply, US Dollar, and Inflation/Deflation Watch "Neither a wise man nor a brave man lies down on the tracks of history to wait for the train of the future to run over him." - Dwight D. Eisenhower US Money Supply Adjusted Monetary Base (

13 Page 13 US Dollar Price (DXY) USD Index measured against other currencies ( 00&ed=&size=M&log=0&t=LINE&v=1&g=1&evnt=1&late=1&o1=&o2=&o3=&sh=100&indicators=&ad dindicator=&submitted=1&fpage=&txtdate=#jump)

14 Page 14 Inflation/Deflation -Year to Date price increase in commodities and basics as measured by futures (

15 Page 15 Velocity of Money Velocity is a measure of how quickly money is spent. High velocity is typically a precondition for inflation. (

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