You have heard us say it time and again. One of the keys to long-term investing success is (cue the drum roll) … diversification!!
There is a mountain of empirical data that supports using a diversified portfolio. The tough part is knowing that at any point, certain asset classes – or investment categories – are going to do well while others struggle. There is nothing we want more than for each piece of the portfolio to do well all the time. Unfortunately, that is just not the way things work.
I like to say diversified portfolios are like horse races. Some horses are viewed as the strongest runners (think U.S. large-cap stocks) while others may be slower out of the gate (bonds). However, it is difficult to know which will be in the lead, and which will be bringing up the rear at any given time. And just like with a horse race, there have been many times where the least likely asset class ends up being the “winner” in any given year.
But diversification alone is not the only key to this success. The other component is time. Markets are volatile, especially in the short term. However, that volatility is much more muted when viewed over longer time horizons. This chart shows the range of returns for stocks, bonds, and a 50% stock / 50% bond allocation over 1-, 5-, 10-, & 20-year rolling periods between 1950 – 2020. This 70-year period covers significant market events like double-digit inflation in the late 1970’s, the Great Recession, and the Covid-19 shock.
The range of outcomes for the 1-year time periods are the most dramatic, especially for stocks. However, that volatility diminishes considerably over longer time horizons. The range of high & low returns for each 20-year rolling period are much tighter than the shorter time frames. Over that 70-year period, the average annual return for stocks was just over 11% compared to approximately 9% for a 50/50 allocation.
Over the long term, being diversified can not only provide respectable returns but also helps smooth out the ride. This is most valuable when we go through difficult times like last year’s Covid-19 market meltdown. It is not easy when we go through these challenging events, but we have seen that a broad mix of investments can weather the storm given enough time. That is why it is important to remember… diversification is your friend.