How Diversification Became a Four-Letter Word

For the fifth consecutive year, responsible financial advisors all across the country are apologizing to their clients.


Because the diversified portfolios they have built are lagging the S&P 500 … for the fifth consecutive year.

Total returns image of 2012 to 2016

Any way you slice it (from conservative to aggressive), diversification has failed to keep pace with the S&P 500, which has generated an annualized return over the past five years of 15%.

“Why aren’t we holding more S&Ps,” they ask. “That is what’s working. Even a monkey could see that.”

Indeed, and monkeys can be pretty good investors at times, simply by throwing darts. But I digress.

The ratio of U.S. stocks to the rest of the world is at a record high. While the S&P 500 has doubled since the start of 2012, the MSCI World excluding the U.S. (ACWX) is up only 25%.

S&P 500 to MSCI world ex-US image

Compared to bonds, the gap is even wider, as the largest U.S. bond ETF (AGG) has generated a paltry 2% per year since 2012 versus 15% for the S&P 500. Here too the ratio is currently at all-time highs.

Total returns since the start of 2012 image

And that’s how diversification became a four-letter word.

International bonds, U.S. investment grade bonds, U.S. Treasuries, Asia-Pacific stocks, European stocks, and Emerging Market stocks have all massively trailed U.S. equities over the past five years.

In the iShares asset allocation ETFs suite, U.S. equities make up just 42% of the portfolio in the most aggressive portfolio (AOA) and only 17% in the most conservative (AOK). It is mathematically impossible to keep pace with an unrelenting run in U.S. stocks when you own anything other than U.S. stocks.

Fund holdings as of june 2016

Does that mean investors should abandon diversification and go all-in, putting 100% of their portfolio in the S&P 500?

  • Only if they are 100% sure that the next five years will look exactly like the past five (unlikely, as the S&P 500 has outperformed the MSCI World ex-US Index in 54% of calendar years, little better than a coin flip).
  • Only if they can handle significantly higher volatility (since 2012, the S&P 500 has an annualized volatility of 13% vs. 6% for the AOM moderate allocation ETF).
  • Only if they can handle much higher drawdowns (the S&P 500 lost 37% in 2008 vs. 10% loss for a 40/60 allocation to US stocks/bonds).

Of course, no one can be sure of what will happen over the next five years and few can handle higher volatility/drawdowns than their risk tolerance suggests.

Which is why we diversify in the first place: to protect ourselves from the unknowable future and the visceral responses we all have to volatility/drawdowns. That protection is nothing to apologize for, even if it means massively underperforming the S&P 500 over a five-year period. To the contrary, it is something to be lauded. It is far easier today to give in to your clients’ complaints and take a punt on the S&P 500 than it is to defend diversification. But defend it you must if you wish to remain a professional in this business, for a large part of what you are being paid for as an advisor is protecting your clients from themselves.

Anyone can go out and buy the S&P 500; the problem is that few can stick with it through the ups and downs. In any case, the S&P 500 is not your benchmark as an advisor; your benchmark is helping your clients meet their goals by taking the highest probability path. That path necessarily includes diversification and excludes betting the ranch on any one stock or asset class.

Your clients may not remember the last time the S&P 500 had a down year (2008) or care to learn about historical drawdowns, but it is your job to educate and remind them of two things: 1) there is no such thing as risk-free reward, and 2) diversification is the highest probability path to meeting their objectives.

Rolling drawdowns 1928 till 2016 image

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.



Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.


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