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Volume 12, Edition 33 | November 13 - November 17, 2023

Diversification: Winning Even if It Doesn’t Feel Like It

Doug Walters, CFA
This week in our series on guiding principles, we unpack the ‘free lunch’ that is diversification. Discover why the clear benefits of diversification might have you feeling like you are losing even as you outperform.

Contributed by Doug Walters, David Lemire, Max Berkovich, Eh Ka Paw

This week, we continue our series on our guiding principles, focusing on diversification, the free lunch in finance no investor should not pass up. Diversification is a guardian against the unpredictable ebbs and flows of the market and a cornerstone of our belief in preparation, not prediction. Yet, so often, investors second-guess its benefits. Why? Because even when they are winning, it can feel like losing.

But first… what do we mean by diversification? It is the act of spreading the assets in your portfolio across different classes, industries, and geographic regions. It is the avoidance of risks like home bias. The goal is to spread exposure in such a way as to try to maximize risk-adjusted returns. Therein lies the magic. A diversified portfolio can often produce more return for a given amount of risk taken.

Let’s take a simple example to explain… owning the S&P 500 and Gold individually and together. Since 1999, the S&P 500 has risen about 7% per year. Gold, about 7.8%. If you combine them equally into a portfolio and rebalance every month, intuition would say you’d earn a return between those two numbers, but you’d be wrong. Instead, the return would be about 8%. Not only that, the volatility of your portfolio would be much lower than owning either in isolation. Magic? No. Diversification.

So why do holders of diversified portfolios often feel like they are losing? There are two effects here:

  • When the stock market is ripping, a diversified portfolio will likely lag. Some holdings will keep up with or beat the market, but others will lag. There will inevitably be buyer’s remorse. Why do I own these lagging asset classes? The diversified investor feels disappointed.
  • When the stock market is down, a diversified portfolio will likely outperform. Diversified holdings like bonds or gold may provide some ballast, leading to relative outperformance. But the portfolio overall is down… and that doesn’t feel good. So, the diversified investor feels disappointed.

Yet, over time, the diversified portfolio can produce higher risk-adjusted returns than the undiversified portfolio. The true joy in a diversified portfolio is experienced by the evidence-based investor with the patience and understanding to watch the long-term benefits play out.

The paradox of winning while feeling like you’re losing with diversification highlights one of the many battles between emotion and evidence in investing. The benefits of diversification manifest not in the immediate thrill of a soaring market but in the measured, long-term journey toward higher risk-adjusted returns. Our guiding principles are designed to advantage clients with either higher returns or lower risk. Diversification is unique in that it has the potential to offer both for the patient investor!

8.0%

Return of the S&P 500 and Gold

We discussed the simplified example of diversification with the S&P 500 and Gold and how the returns of the combined portfolio are higher with lower risk than the individual parts. The table below provides a complete overview of the data.

S&P 500Gold50/50 Mix
Return7.0%7.8%8.0%
Volatility15.3%16.4%11.4%

Based on data from 12/31/1998 – 9/30/2023, rebalanced monthly.

Headline of the Week

The Captain Has Turned Off the Fasten Belt Sign

In this sense, the Captain is the market, which has largely priced in the “soft landing” for at least the U.S. economy. Declining inflation coupled with low unemployment and a resilient consumer are the themes behind this unbuckling and the resumption of risk-taking. It is not exclusively the “Magnificent Seven” this time, but small caps have come along for the upward ride, and yields have declined considerably.

Some are heeding the second part of these typical cockpit announcements, “while in your seat, please keep your seat belt securely fastened in case of unexpected turbulence.” Turbulence could come from the Fed. While further rate increases appear increasingly unlikely, the market seems to be aggressively pricing in rate cuts – sooner rather than later. The Fed remains non-committal and consistently emphasizes “for longer” when addressing higher rates. Should the Fed and Markets broadcast conflicting messages over the PA, we could see those not buckled in get bounced around.

The Week Ahead

A holiday-shortened week is expected to be uneventful. However, the last of the “magnificent seven stocks” reporting earnings and minutes of the Federal Reserve’s November 1st meeting on Tuesday could move markets, especially with light trade volume.

Every End is a New Beginning

The minutes of the last meeting of the Federal Reserve will be released a bit earlier due to the holiday.

  • The end of the hiking cycle is in sight or may already be here, at least according to the markets.
  • However, the markets have already jumped to the slashing cycle, with markets penciling in 2nd Quarter of 2024 for the start line.
  • The post-meeting statement provides few clues about the Central Bank’s direction, so examining the information closely will be crucial to determining its direction.
  • Meanwhile, economic data since the meeting has been somewhat soft.
  • Next week, durable goods orders and housing data are scheduled, followed by an OPEC meeting and PCE inflation report the week after.

End of the Line

Earnings season comes to a trickle with Nvidia (NVDA) and Deere (DE) as the last of the marquee names to report.

  • NVIDIA faces a very high bar when it reports, as the stock has been the poster child for the artificial intelligence boom.
  • The stock is up over 200% this year, surprising investors with even hotter numbers last quarter than optimistic expectations.
  • Currently, profits per share estimates for 2025 are $14.60 per share. That compares to $3.34 for 2023.
  • John Deere reports on Wednesday and will offer some color on agriculture spending.

Speaking of Agriculture…

Enjoy the mashed potatoes with your Turkey on Thursday.

  • We are wishing you all a Happy Thanksgiving!
  • Go out and stimulate the economy on Black Friday, but not too much, or the Fed will raise rates.
  • The market is closed on Thursday and will have an abbreviated session on Friday.

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