Diversification is a core principle of
our investment approach. With equities,
for example, not only do we diversify across sectors and industries, but we
also diversify among both domestic and international stocks. Within domestic stocks we maintain exposure
to both large and small companies, and internationally we hold some funds
focused on developed international markets and others invested in emerging
markets.
Our standard mix for stocks is
60% large U.S., 15% small U.S., 15% established international markets, and 10%
emerging markets.
Diversification is primarily a tool to
help control risk, but this mix has also added considerable value in the long
run. For example, over the past 15
years, equity indexes in our typical blend have outperformed the S&P 500
index by a significant 0.7% per year. While
its long-term performance has been great, relative performance in individual
years is, of course, highly variable. In
2014, equity indexes in our standard blend lagged the S&P 500 by 5.8%!
The S&P 500’s total return in 2014
was 13.8%, its third year in a row of double-digit gains. Small U.S. stocks (the Russell 2000), in
contrast, returned only 4.9%, while established and emerging stock indices each
produced negative returns (-4.5% and -2.2%, respectively). Consequently, the blended equity index
representing the diversified mix of equities we typically hold in client
portfolios returned 7.9% in 2014. That’s
respectable, but seen through the lens of this past year alone one might say
that equity diversification didn’t pay off.
However, if every asset in a portfolio is going up at the same time,
it’s a strong sign that the portfolio is not diversified. The whole point of diversification is
reducing risk by holding assets that don’t move together and improving long-term,
risk-adjusted returns.
Looking ahead on the domestic front,
economic growth seems to be picking up, inflation remains tame and interest
rates low, and seasonal influences remain positive for stocks. Internationally, the picture is less
encouraging with positive, but slowing growth in China and economic stagnation
gripping Europe and Japan, despite extremely low interest rates. Additionally, sharply falling currencies in
Japan and Europe increase the risk of a global trade war. International equity valuations are generally
good while domestic equities are quite expensive on the basis of some of the
most useful valuation measures, and most expect U.S. interest rates to rise this
year. High domestic valuations and rising
rates have traditionally been a bad combination. With 2015 likely to offer significant
crosscurrents, diversification should be more helpful in the year ahead.