If The Bull is Still Running, Why Diversify?

U.S. stocks have been on a decade-long tear. According to recent comments from Omar Aguilar, chief investment officer for equities at Charles Schwab Investment Management, the bull market “could extend for another 18 to 24 months.” In this bull market environment, any effort by financial advisors to talk to their clients about diversification often falls on deaf ears. The current trend against diversification makes "sense" because of the current market conditions. However, historical data has demonstrated that for long-term gain, now is a crucial moment to diversify.  

Yes, U.S. stocks have had a great run. But if you look a little closer, the story isn’t the same in every corner of the equity market. Energy stocks, for example, have taken a beating. Anything related to oil and gas from major players like Exxon (XOM) and Sunoco (SUN) to pipeline providers such as Kinder Morgan (KMI) and Williams Companies (WMB) and servicing firms like Halliburton (HAL) and Baker Hughes (BHGS) are well off of their highs.

The same can be said for retail stocks like Limited Brands (LB), Sears (SHLD) and even Macys (M). In fact, much of the S&P 500 falls into the same camp, with overall results propped up by just a few high-flying technology names. Yet, even among tech shares all is not necessarily rosy. Just take a look at Facebook (FB) and Netflix (NFLX), the once high-flying members of the so-called FAANG stocks that were defanged when they posted disappointed numbers.

In fact, right around same time Aguilar expressed his view that the bull market will continue, Michael Wilson, Morgan Stanley’s chief U.S. equity strategist said the stock market is already in a rolling bear market, with technology stocks as the exception to the rule. Wilson expects tech stocks to see a 10% drop in price followed by a continued market advance.

Individual stocks aren’t the only area of the market worth a closer look. Charlie McElligott, head of cross-asset strategy at Nomura, noted that the “three-day move in U.S. ‘Value / Growth’ has been the largest since October 2008.” His comments followed the notable declines in the value of technology stocks at the beginning of August 2018. Led by tech stocks, so-called growth stocks have outperformed value stocks in recent years.

Analyst and investors who believe in mean reversion have been expecting a change in leadership, expecting value stocks to outperform growth stocks. Their belief is supported by a Bank of America/Merrill Lynch study that looked at growth and value stocks over a 90-year period and determined that growth stocks returned an average of 12.6% annually while value stocks returned 17% annually. If history is any judge, value looks good for the long run. Of course, growth has done well in the recent short run.

Warren Buffet, the man widely recognized as perhaps the greatest investor of all time, also has a notably interesting underlying story. The Oracle of Omaha, as famed value investor Warren Buffet is known, sat out the dotcom bubble in the 1990s. He explained that he didn’t invest in companies that he did not understand. His critics said that he was out of touch with the times and that his style of value investing was a relic of the past.

When the market crashed in early 2000, Buffet was suddenly back in favor. Yet, after becoming well known for avoiding technology stocks, even the Oracle changed his ways. Today, Buffet’s firm, Berkshire Hathaway, holds $50 billion worth of stock in Apple—Berkshire’s largest holding. Diversifying into tech paid off big for Buffet.

The current trend against diversification has many parallels in the history of investing. Almost any time the stock market does something unusual, you hear the mantra “things are different this time.” A record-setting bull market fosters the expectation that the good times will never end. Falling oil prices create the impression that prices will never go back up. The success of Amazon (AMZN) set the expectation that traditional retailing is dead and that malls cannot survive. A long period of outperformance by growth stocks suggests that value stocks will never lead the market again. Yet, history has shown us time and time again that market leadership changes over time, winners and loser come and go, and trying to make the right buy and sell decisions at just the right time is generally a fool’s errand…which brings us back to diversification.

In 1830, Massachusetts Justice Samuel Putnam directed investment trustees "to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested." This mandate is widely recognized as one of the first directives to recognize that investors should consider risk as well as return when making investment decisions. The same logic applies to individuals.

Accordingly, taking on undue amounts of risk in pursuit of gains is not prudent. Believing that “it’s different this time” (despite decades of history suggesting the opposite) is not prudent. Defensive investing is prudent. Diversification is prudent. It’s the simple act of making sure all of your eggs aren’t in one basket.

In investment terms, diversification means making sure all of the risk in a portfolio is not concentrated in a single asset class (like high-flying U.S. equities). It’s the reason professional investment advisors recommend allocating assets across a variety of asset classes, often including both domestic and foreign stocks, large-cap and small-cap stocks, corporate bonds and government bonds.

Yes, diversification means that investors won’t enjoy the maximum possible gain that the best-performing asset delivers. It also means they won’t suffer the maximum possible loss that the worst-performing asset delivers.