Over the last few years, stocks in the United States have outperformed their international counterparts. Lately, US bonds have lost value as yields have risen. We occasionally get questions from clients about why their portfolio has underperformed compared to the Dow Jones index or S&P 500 index. The reason comes down to diversification. Diversification is basically the idea that you don’t want to “put all of your eggs in one basket”, since diversifying among different asset classes (stocks and bonds, US and international stocks, large and small company stocks) will protect your portfolio from any one asset class performing so poorly that it permanently hurts your portfolio. As Ben Carlson has said:

Diversification is about accepting good enough while missing out on great but avoiding terrible.

The Dow Jones and S&P 500 indexes are composed of 100% United States large-cap stocks. This differs significantly from investor portfolios, which are invested across different asset classes and regions. Since their components are so different, we cannot expect for investor portfolios to behave like the S&P 500 or Dow Jones indexes.

While it is difficult to feel that you are being left behind as US large-cap stocks outperform the other asset classes that you own, we know that valuations matter and that all asset classes revert back to the mean. That simply means that an asset class won’t go up forever, but instead will eventually fall out of favor. Similarly, an asset class won’t underperform forever, but instead will eventually outperform. Many investors wanted all tech stocks in the late 1990’s…until the tech bubble burst. At that point, value stocks and bonds didn’t look so bad. There were a lot of investors that thought real estate would rise forever…until the great recession of 2008/2009 reminded them of why they own bonds. And US large-cap stocks will do well….until they don’t. Since international stocks are cheaper than US stocks and since eventually international stocks will outperform US stocks, we want to make sure we are investing part of your portfolio in international stocks. Although yields on bonds are currently rising (which pushes the value of bonds down) we know that long-term, most of a bond’s return comes from the yield and the subsequent interest that is paid. Therefore, we are happy to see higher yields on bonds even though some short-term pain will be incurred.

The bottom line is that there are tried and true basics that we stick with in investing, such as diversification and low cost investing. We also know that it doesn’t feel good when one of the asset classes in your portfolio is outperforming (why don’t I have more of this asset class?) or if one of the asset classes in your portfolio is underperforming (why do I have any of this asset class?). Our thought process on investing is this – in order to accomplish your goals, you need to invest. To invest means taking on some risk. However, diversification helps reduce the risk of having any one asset class blow up and destroy years of savings. Therefore, our advice is to stay the course and stick with your asset allocation (mix of stocks and bonds) consisting of diversified, low cost holdings.

If you would like to read more about the historical performance of US stocks versus foreign stocks, click here for an article by Ben Carlson entitled “Diversification is No Fun”.

As always, we are happy to speak with anyone about their portfolio or particular situation.

Your Partners in Financial Planning investment team.