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Diversification undervalued when it’s needed most

The stock market is soaring higher than ever with large-cap names, as well as small-caps, hitting all-time highs recently. The S&P 500 hit its high mark in intraday trading on Aug. 29, the Russell 2000 on Aug. 27.

Strong earnings growth and 40-year highs in both consumer and business confidence were enough to overcome recent volatility brought on by trade war fears, threats of inflation and a daily cacophony of chaos coming out of Washington. To be sure, there will always be a morbid mob of pundits and prognosticators who fear market highs and want you to fear them too. Negativity always sounds more robust and reasoned than outright optimism.

The S&P 500 posted its biggest gain since November.
A trader wearing a "Dow 26,000" hat works on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Tuesday, Jan. 16, 2018. The Dow Jones Industrial Average plowed past 26,000 as optimism over corporate earnings turbocharged the equity bull market. Photographer: Michael Nagle/Bloomberg

Meanwhile, other investors may begin to question traditional investing wisdom and just buy whatever is “hot.” If U.S. large-cap stocks are outperforming other asset classes, these investors may be inclined forget about risk and downside potential and ask, “Why don’t we just own U.S. large cap stocks and call it a day?” Indeed, in positive markets, it can be easy to forget why it is in the investor’s long-term interest to own a variety of strategies such as bonds, REITs, emerging market stocks, international stocks, small and midcap stocks, and cash.

So what’s the lesson for clients?

Much like a sports team or Broadway play, each contributor plays a different but pivotal role in the overall performance, and each plays that role only at the appropriate time.

First, there is nothing inherently dangerous about market highs. Indeed, over the past 90 years, the average return after market highs, over the subsequent six and 12 month periods, has been better than average performance, not worse. This fact is not mentioned in any of the “the sky is falling!” articles, however.

Moreover, instead of fearing the highs, or loading up on hot stocks, the better strategy would be diversifying.

The idea that all asset classes do not move in lockstep is exactly the point of developing a thoughtful long-term wealth management plan. It is what keeps investors from experiencing the full pain of an inevitable stock market correction when it occurs. And diversification is especially essential at times of market extremes.

Many investors remember that the S&P 500 lost 39% of its value in 2008, but few recall that the 10-year government bond gained 21% that year. While the 10-year bond may not be an exciting investment vehicle nor its yield a titillating topic at a cocktail party, a balanced portfolio of both stocks and bonds held up much better in that challenging year than holding stocks alone.

Over the past 90 years, the average return after market highs has been better than average performance, not worse. This is rarely mentioned in the “the sky is falling!” articles.

Likewise, many investors may now question their emerging market holdings when looking at the sector’s loss of 6% so far in 2018. They may also remember that emerging market stocks lost 53% in 2008. But few investors recall that emerging market stocks gained 40% in 2007, 79% in 2009 and 38% in 2017. Many investors may scoff that REITs have only gained 1% in 2018, but few remember that REITs averaged yearly gains of 19.1% over the six-year period of 2009-2014.

With paltry returns in the corporate high-yield bond market this year of 0.1%, it may feel like it is time to sell those bonds and buy more stocks. However, the inclusion of high-yield bonds in a well-diversified wealth management plan has paid off during the current market cycle, with the group’s average yearly return of 10.8% since 2009. With huge technology companies like Amazon, Facebook and Google now household names, why would we want to hold midcap stocks? Because even with their smaller company size, the group has averaged a 17.6% average yearly gain over the past nine years.

During happy times in the stock market, it can be easy for an intelligent investor to forget why he or she would want to continue to hold a well-diversified portfolio of strategies and asset classes. Much like a sports team or Broadway play, each contributor plays a different but pivotal role in the overall performance, and each plays that role only at the appropriate time. This diversification is essential in riding out the ebbs and flows of global economic cycles. With a diversified asset allocation plan, some asset classes or strategies will always seem boring or unessential at times.

This is how we know that we are managing downside potential. This is how we know that our financial legacy is not at risk. And this is how we know that we are positioned to prosper through any inevitable market downturn or market chaos.

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