Smoother Ride“I’m gonna put all my eggs in one basket ... and watch the basket!” Often entrepreneurs who have made their fortune through the fruits of their business voice this as their “preferred” investment strategy. With patience and courage this strategy can generate solid long term returns but the road to the longer term has serious peaks and valleys, switchbacks and straightaways, bumps and bruises. Too often this investor doesn’t get to the longer term because he or she sold when the valley was steep and the switchbacks seemed endless.

Putting different eggs in our basket with the hope of earning a good longer term return but with a much “smoother ride” is a risk management technique known as diversification. The rationale behind this concept is that each egg could earn a decent return on its own over time and that each will behave differently enough from one another for some of the eggs to neutralize the occasional negative performance of others. Consider the two egg basket in the nearby graph.

Both eggs, or assets, generated a positive return over time but when one is increasing the other is decreasing. They are completely out of phase, or “uncorrelated.” The dotted line is the net effect, as smooth an uphill ride as there is.

The challenge with diversification is that, with almost certainty, in any given period, one or more of the eggs in the basket will perform better than the basket itself. Sometimes, way better. When one of the well-known eggs does better, like the S&P 500, commentators might say that “diversification didn’t work!” Nothing is farther from the truth. Diversification worked perfectly well but the basket effect diluted the return of the best-known egg. Take a look at the investment “periodic table” nearby.

The diversified 60% stock / 40% bond Asset Allocation portfolio generated a 6.7% return the last ten years. The S&P 500 (in green) returned 7.7% during the same time frame. Clearly 7.7% is one percent higher than 6.7%. But examine the path the 60/40 portfolio took. Like Goldilocks’ porridge it was not too hot not too cold, just right. Smooth. Much smoother than that taken by the S&P. Now, trace the path of the asset at the upper right, Emerging Markets (MSCI EME, light purple). Its 8.8% 10 year return is a full two percentage points better than 60/40, but its path is the absolute opposite of smooth. Only you can answer whether the potential for the extra 2% return is worth the gut wrenching variability in return, year to year.

A maxim of investing is that it is always clear what we should have done, after the fact. The S&P 500 has been advancing for almost six straight years; not a record, but close. That advance has made many investors wonder why they are invested in a 60/40 portfolio instead. If your risk tolerance suggests a 60/40 allocation, be patient. Someday, in the foreseeable future, stocks will back off, maybe by a lot. It is the natural order of things. That might be the next time you are glad you chose a smoother ride for your portfolio.

If you have questions regarding this weeks ‘Under the Hood,’ contact Chief Investment Officer, Mike Weiner.

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