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DIWORSIFICATION

January 12, 2015
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    Diworsification

    Di-wors-ification: making additional investments into a portfolio and actually worsening the risk/return tradeoff. The term, coined by legendary Wall Street investor Peter Lynch in his 1989 book One Up On Wall Street, has never been more fitting than it was in 2014. Traditional “diversification” — mixing a wide variety of investments within a portfolio to, on average, yield higher returns and less risk than an individual investment — did not work last year. While the S&P 500 was up 13%, small cap stocks were up only 4%, emerging market stocks were down 2%, developed market stocks were down 4% and commodities were off 17%. Basically, large U.S. companies did well, but almost all other investment styles “diworsified” the result. Knowing this, many American investors have become impatient with the philosophy of diversifying investments. I would tread carefully down this path of thinking, though. We need not go back any further than the technology and financial bubbles of the 2000’s for a good reminder. In fact, a 20-year snapshot from 1994–2013 shows a diversified portfolio of large and small cap stocks, international stocks and diversified bonds generated average annual returns of 8.3%; at the same time, the S&P 500 captured average annual returns of 9.2%, but with 50% more risk (BlackRock, 2014). Yes, it’s been difficult keeping pace with the S&P 500 the last few years (ask Wall Street’s top hedge fund managers), but it’s only a matter of time before “diworsification” becomes “diversification” again.

    In summary, here are 2014’s major index returns (with dividends):

    S&P 500 = 13.69% Barclay’s US Aggregate Bond = 5.97%
    MSCI All-World ex US (international) = -3.87% Bloomberg Commodity = -17.01%
     

    And here is a comparison of the general market changes from 2013 to 2014:

    Stock Indexes (price only)12/31/201312/31/2014Difference (%)
    Dow Jones IA16,57617,8231247 (7.52%)
    S&P 5001,8482,058210 (11.36%)
    NASDAQ4,1764,736560 (13.41%)
    Yields and Rates   
    10-Year US Treasury Bond3.04%2.17%-0.87% (-28.62%)
    6-Month CD0.27%0.27%0.00% (0.00%)
    30-Year Fixed Mortgage4.64%4.02%-0.62% (-13.36%)
    Commodities and Currency   
    Gold Price$1,205$1,206$1.00 (0.08%)
    Oil (WTI) Price$98.42$53.27-$45.15 (-45.87%)
    Dollars per Euro$1.38$1.21-$0.17 (-12.32%)
     

    Reading between 2014’s lines suggests equity investors are comfortable taking on more risk with 3rd quarter economic growth at its strongest pace in 11 years. S&P 500 prices are 6% above their 60 year average, but in comparison to our historically low interest rates that’s still cheap. It’s also been 15 years since the NASDAQ approached its March, 2000 high – as the only major index not to surpass its previous high, it appears determined to do so in 2015. 10-year Treasury prices could remain strong with a strengthening dollar and an inflow of foreign investment from struggling global economies. Banks still don’t want our deposits as paltry CD rates were unchanged for the year. Continued excess home supply and weak household formation dampened the housing recovery and saw mortgage rates swoon near 4%, but these factors are fading (last chance to re-fi?). With the domestic economy strengthening and no evidence of a recession looming, gold was unchanged for the year. And oil – the pink elephant in the room - dropped 46% in 2014. Finally, the dollar strengthened against foreign currencies last year and this relationship could continue if the Fed raises short-term rates while global central banks lower them. A stronger dollar could mean lower oil and commodity prices – further lining Americans’ pocketbooks and elevating corporate earnings and, in turn, lifting U.S. stocks. Two areas to watch in 2015: 1) dividend paying stocks – considered over-priced by some, if the Fed raises short-term rates, their dividend yields could face competition from other investments; and 2) gold – with oil and global economies shaky, the precious metal’s value could fall if inflation remains benign.

    Posted by Ford Lankford

    Ford N. Lankford is a Portfolio Manager at Russell Capital Management (RCM). He manages investment portfolios and consults on investment planning for personal and institutional clients, as well as retirement plan sponsors and participants. Read more ›