Don’t Overthink Diversification Strategies

Don’t overlook the investment potential with companies that are under-valued.

By Craig Novorr

     Investment professionals have always sold the idea of diversification: Invest your assets in multiple segments of the markets to reduce risk. The most used segments of the markets include stocks, bonds, real estate and commodities. Within stocks, investors further diversify using international, emerging markets, large cap, mid-cap, small cap, growth and value investments. 

    Warren Buffett once said, “Wide diversification is only required when investors do not understand what they are doing.” That leads to a simple question: Is diversification the best approach to investing, or is diversification an easier sales pitch for investment professionals with little fundamental knowledge of companies or the markets?

    Like most things in life, keeping things simple usually yields the best results. By using common sense to invest in what you know and understand, your portfolio will perform well over time.  In addition, when volatility increases in the markets, you will have greater peace of mind because you understand why you own certain investments in your portfolio.

    A common recommendation from a financial planner or wealth manager typically includes 20 percent international stocks and 10 percent emerging markets, along with the rest of the nine style boxes of large cap, mid cap, small cap, growth and value ETFs or mutual funds.  Let’s look back since the financial crisis in 2008 at three ETFs (Exchange Traded Funds) that represent the broad markets. EFA represents Europe, Australia and the Far East, EEM represents emerging markets, and SPX represents the S&P 500, or 500 large companies on the U.S. exchanges. 

    Since the highs of the markets in the beginning of 2008, a variety of events affected the markets—the financial system collapse, the Greek bailout, the crumbling of the Euro, the economic slowdown in China, oil prices plummeting, terrorist attacks all over the globe, and most recently Britain’s vote to leave the European Union. With all those events happening, the S&P 500 bottomed out in March 2009 and has more than tripled since then. During that same period, however, international and emerging markets have not kept pace.

    Some numbers to better illustrate this point: from March 2009-August 2016, the SPX (S&P 500) annualized at 19.37 percent return. The EFA (international) annualized at an 11.88 percent return, and EEM (emerging) at 9.98% per year. 

Over the past eight years, foreign markets have under-performed U.S. markets, an outcome that should prompt investors to re-assess diversification strategies.

    In hindsight, it is easy to see the U.S. outperformed the rest of the world, but even at the time, it was clear the U.S. was leading the rest of the world in recovering from the aftermath of 2008.

     Over the past eight years, U.S. markets have continued to rise, while others have struggled to keep pace. Predicting the future is hard, and tends to be a
fool’s errand. Using a straightforward and common-sense approach to evaluating the current market environment,
investors will see that Europe is still trying to figure out how to exist in a post-Brexit world. 

    As concerns over other countries’ leaving the European Union linger, continued slowdowns in growth in emerging markets, China in particular, and around the globe are real concerns for sustained future growth. Yet most investors remained fully invested in international and emerging markets over the past eight years and have maintained their allocations to these areas going forward.

    To be clear, this is an example looking backward over the past eight years and does not mean that international and/or emerging markets won’t do better than the S&P 500 in the future. The point I am making is that we could see the struggles in Europe, China, and around the world continue with most investment managers and do-it-yourselfers taking no action within their portfolios.

    The alternative is to look at investing up-side down! The traditional diversification model we have been discussing is referred to as Top-Down investing. The alternative is Bottom-Up investing. Our belief is to invest in good, quality companies that we believe are under-valued, instead of focusing on diversifying asset classes and geographic locations. The markets tell us where there is value by looking at a company’s fundamental characteristics then comparing the company’s stock price to its intrinsic value (where the company’s stock price should be).

    Using a simple and common-sense approach, you can invest in a portfolio of stocks and bonds allocated to reach your investment goals, while staying within your risk tolerance. In the end, you’ll sleep better with an approach you can understand—and better yet, explain to someone else. 

About the author

Craig Novorr is president of Paragon Capital Management in Overland Park, Kan.

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