Broker Check

Diversification

March 19, 2017
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How diversification helps and hurts your investment returns

My colleagues and I are often asked a question along the following lines:  Why didn’t my account do as well as the S&P 500 or the DOW?  The S&P includes 500 major US companies.  The DOW is comprised of only 30 US companies.  Unfortunately, TV and radio reporting usually only tell us how the US stock markets are performing.  Our regular media sources fail to help investors see the more complex picture.

2016 is very instructive in providing an answer to the performance question noted above.  Assume you have a three part account comprised of US companies, foreign companies and US corporate and government bonds. 

In 2016, the US company portion did well as measured by the S&P 500 or the DOW.  Let’s look at the other two parts of our hypothetical account.

During 2016, the US dollar strengthened versus other world currencies.  Your foreign company values were negatively impacted by the dollar strengthening.  The negative impact created by a stronger dollar reduced the returns of the non-US holdings in your account. 

Higher US interest rates hurt bond values.  As interest rates go up, the value of existing bonds moves in the opposite direction.  The longer the bond has to maturity, the more the value is negatively impacted by rising rates.

In 2016, the strengthening dollar and rising interest rates were responsible for moderating our hypothetical portfolio results.  The point is by no means to limit diversification or to try to time allocation moves.  Broad diversification is intended to moderate volatility.  The combined return of multiple parts blends the good, the bad and the ugly.

Brian Portnoy, PhD, CFA penned a report for investment advisors associated with the issues just noted.  The article is appropriately titled:  “Diversification Means Always Having to Say You’re Sorry.”