Articles

Don't Look to the Past: Base Wealth Strategies on Diversification

By Ron Ross | December 17, 2015

Sometimes, clients wonder if basing current and future investment decisions on past performance is a good idea. After all, we’re often told to take a lesson from history.

Ron Ross is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt CountyWhile learning from the past may be a good idea in many areas of life, as it turns out, when it comes to investments – not so much. Here’s why past performance isn’t always the best way to predict future results.

History Doesn’t Repeat Itself

As much as we all wish the opposite was true (because it would certainly make everyone’s life a lot easier!), history doesn’t repeat itself in the investment market. As a rule, asset classes of all types – from U.S. Large Cap to International Small Cap, Emerging Markets to Five-Year U.S. Government Fixed – don’t behave predictably or consistently.

Assets’ random nature means that it’s virtually impossible to predict future market movements based on past results. The good news is that the strategy of combining asset classes into diversified, well-balanced portfolios mitigates – or even eliminates -- much of the randomness.

Random Returns

The following slide illustrates the issue.

Ron Ross is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt County

Here’s a detailed look at the annual performance of major asset classes in the U.S., international, and emerging markets from 1998 to 2012.

  • The top chart ranks annual returns year-by-year over the 15-year period from highest to lowest; each color corresponds to a specific asset class.

  • The bottom chart displays overall annual performance by asset class.

As you can see, in both U.S. and non-US markets, asset class performance varies significantly from one year to the next – in fact, it’s random.  Studying the annual data reveals no obvious patterns to be exploited for excess profits, underlying the argument for broad diversification across many asset classes.

Almost Perfect

Every investor has different financial goals, time horizons, and risk preferences, and each individual portfolio should reflect those differences. And although there’s -- unfortunately -- no such thing as the "perfect" portfolio, for most investors, diversification across multiple sources of risk and return represents the most sensible approach.

You’ll notice that the following examples of model portfolios fall at different spots along the risk/return spectrum, thus illustrating different ways to capture the equity, size, and value risk premiums in global markets.

Ron Ross is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt County

To keep it simple, the relative proportion invested in equities is fixed; rather, the changes across the model portfolios reflect the benefits of diversification across a greater number of asset classes.

Minimizing Volatility

As we’ve seen, asset class returns vary significantly from year to year, making it impossible for your wealth advisor to offer investment guidance and wealth strategies based on past returns. However, combining multiple asset classes minimizes the volatility while global diversification reduces the random effect of a single asset class or market.

Ron Ross is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt County

  • The upper chart ranks the year-to-year returns, from highest to lowest, of model portfolios from 1998 to 2012.

  • The lower chart illustrates the historical annual performance of the model portfolios over the fifteen-year period; columns on the right reflect overall annualized returs and standard deviations.

Ron Ross is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt County

You’ll notice that the dispersion of colors is much more uniform and consistent than in the first example. Why?

Greater diversification.

Diversified, balanced portfolios can reliably capture the returns associated with spreading multiple measures of risk across global asset classes and markets.

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