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Diversification Works When You Need It Most

Diversification Works When You Need It Most

October 15, 2018

The S&P 500 has had a good run since the start of the decade.  From 2010 through August of 2018, the index has gained +14.0% annually.  Most other stock asset classes around the world have failed to keep pace.  The return on the globally diversified, small-cap and value tilted DFA Equity Balanced Strategy Index has done well but hasn't kept pace with the S&P 500, earning +11.7% per year.

But this isn't the type of market environment where you necessarily need diversification to pay off, the return on the S&P 500 is well above its long-term average of about 10% per year, especially considering the low rate of inflation this decade--just 1.8%.

A look back at previous decades finds that a diversified stock portfolio doesn't always outperform the S&P 500, but it tends to work when you need it most.

The 1970s

Most investors don't remember the 1970s, which is troublesome because it was a difficult decade and illustrates the risks of putting all your stock allocation in one asset class.  From 1970-1979, the S&P 500 earned +5.9% per year, but inflation (CPI) was +7.4% annually.  Net of inflation, S&P 500 investors lost money for an entire decade.  The diversified DFA Equity Balanced Strategy Index faired much better, as global diversification and smaller and more value-oriented stock exposure paid off.  Its return was +13.4% per year over this stretch.

The 1980s

The 1980s were a good decade for investors no matter what you owned. This was one of the only periods in recent history where the S&P 500 had above-average gains (+17.6% per year) and the diversified DFA Equity Balanced Strategy Index performed even better (+22.0% per year).

The 1990s

S&P 500 returns in the 1990s topped even the 1980s; the index gained a whopping +18.2% per year.  The diversified DFA Equity Balanced Strategy Index had strong performance as well, but its +13.7% per year return was several percent below the S&P 500.  Even though the benefits of diversification weren't needed due to above-average returns from large-cap stocks, it was still common to see investors giving up on a diversified strategy to chase the hot asset class.  As we'll see next, this was a huge mistake. 

The 2000s

No asset class can exceed its long-term average forever, and investors who jumped out of a diversified portfolio and into the S&P 500 in the 1990s learned this the hard way during the 2000s.  The S&P 500 experienced its second decade in 40 years with a negative return after inflation.  This time, the S&P 500 had a negative nominal decline as well, losing -1% per year (-3.5% per year after inflation).  But once again, we find that broad asset class diversification could have saved investors from disappointment.  The DFA Equity Balanced Strategy Index outperformed the S&P 500 by 8.4% per year, returning +7.4% annually.  This was the best relative return (compared to the S&P 500) over an entire decade for the diversified DFA Equity Index, at precisely the time when it was needed most (the S&P 500 had its worst decade return).  It bested even the +7.5% per year outperformance during the 1970s (the second worst stretch for the S&P 500).

The 2000s were so good for the diversified index portfolio, in fact, that they totally eliminated the deficit built up (compared to the S&P 500) in the 1990s.  For the entire 20-year stretch, the S&P 500 earned +8.2% per year while the DFA Equity Balanced Strategy Index returned +10.5% per year.

While we cannot be certain that history will repeat, it should none-the-less be comforting to diversified investors to know that there have been many periods when well-balanced portfolios have failed to exceed the return on the S&P 500, despite higher expected returns.  But these have typically been periods when the S&P 500 is experiencing above-average gains, not the type of environment where diversification is needed to generate even higher results.  When S&P 500 returns eventually disappoint -- often after a stretch of above-average returns -- a diversified portfolio seems to have its best relative returns.  Said differently, diversification works when you need it most.

Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.