Part One: Diversification
When I was a young, impressionable tax accountant at the now defunct accounting firm of Arthur Andersen & Co., I fell in love with a chart like the one above at a training session for those of us in the family wealth planning group. To see a larger version of the table, here’s the original I pulled from Callan Associates’ website. We were being trained to help our clients with asset allocation and periodic rebalancing.
Every investment mistake I have ever made was because I tried something different than what I learned that day.
I hope I can make you love this chart too.
As a starting point, look at the column under 1993. That year, the top performing stocks were international stocks, the emerging market index was up nearly 75%. The worst performing category was U.S. large cap growth stocks. At the end of that year you might have decided to put all your money in emerging markets and to sell off your large cap stock funds in frustration. But wait, the next year international emerging markets was the worst performing asset class and U.S. large cap stocks were among the best, although nothing was really stellar that year.
In 1995 through 1998, U.S. large cap stocks consistently came in at the front of the pack and international stocks at the back. But chase that performance and you would have been burned from 2001 to 2007. Bonds performed well from 2000 to 2002, but followed at the bottom of the heap in 2003 through 2006.
I hope you are starting to see the pattern. That is, there is no pattern.
By diversifying across all asset classes, you guarantee that you won’t have the best or the worst performance, you’ll have something in the middle. Yes, you give up the possibility of betting on the winner for that year, but you reduce the risk that you will be the biggest loser.
The more heavily that your portfolio is weighted toward stocks, the more the potential reward over the long-term, but the more risk you are assuming. If you weight your portfolio more heavily in favor of bonds, you decrease the portfolio’s risk, but at the expense of returns in the long-term.
Put me on record here: I have no ability to predict how the market will do from year to year. For the last several years, I have been expecting interest rates to increase. Instead they have decreased. Politics, oil prices, European debt, inflation, natural disasters, or unforeseen shocks to the financial system, I have no idea what’s going to happen. The only way I can stay calm through the ups and downs is with asset allocation and periodic rebalancing.
Tomorrow--Part Two: Asset Allocation
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