Since January 2, we have received a deluge of “annual updates” showing where folks should have invested last year. Just when some of us are starting a new year filled with confidence, hope, and faith in a new year, and maybe with passion for new resolutions, we now read how obvious it was a year ago that we should have been invested in just these two or three future top performers. What is it they say about hindsight?
The fact of the matter is research strongly suggests no one can accurately forecast the future market direction with any success or consistency. Folks who predict accurately one or two years running are just lucky. They do not possess any unique skill, process, or secret algorithm. In the long-term, they will, at best, revert to the mean. In other words, they’ll just be average, if not worse.
In support of our client’s financial goals and objectives, our clients have long-term, goal oriented, and appropriately diversified portfolios. Thus, you should never feel embarrassed or doubt your plan if your portfolio doesn’t keep up with the top sectors over the short term. Such feelings could lead to stress and emotional decision making which will always wreck a portfolio and your financial future. In addition, each year, you should always rebalance your portfolio back to your target asset allocation.
Diversification
Diversifying your investments is how you reduce risk in your portfolio. In other words, by not putting all your eggs in one basket, you earn an expected return but assume less risk in your portfolio. Diversifying is accomplished by having stocks, bonds, alternative investments, and cash in an allocation based on your particular time horizon and risk tolerance. The goal of diversifying is not to enhance return or pick a winning sector year over year, and diversifying does not ensure gains or prevent losses. Rather, diversifying has the potential to improve returns for a certain level of risk.
The concept of diversifying investments is grounded in the theory of Correlations. Correlation, in the investing arena, measures the relationship of the historical returns between two investments. Correlations are expressed as a number between +1 and -1. For example, two investments with a correlation of +1 would indicate that when one investment was up 5% the other would also be up 5%. When assets with low correlation are placed in a portfolio, you may be able to get the same return with less risk or more return with the same level of risk.
Diversifying is accomplished by selecting your investments across multiple assets – stocks, bonds, alternatives, and cash. Additionally, within each asset class you further diversify by investing in sub-sectors of each asset. For example, stocks are divided by the size of the companies such as large, medium, and small companies; the geographical location – US, European, and Far East; by style – growth or value. Each of these sectors are correlated in different ways to the others.
The chart below shows returns of 10 sectors over the last 10 years:
On an annualized basis, mid-size company stocks were the best performing sector, averaging 9.4%. Interestingly, mid-cap stocks were never the best sector in any given year over the last 10 years, and mid-caps were the second best performing sector only once, in 2013. The lowest mid-cap stocks ever ranked was seventh in 2011.
Foreign emerging market stocks were the number one performing sector four times over the last 10 years, but never two years in a row. Foreign emerging market was the best sector in 2012, but has been one of the worst sectors the last two years. The high and low rankings through the years demonstrates the market volatility of foreign emerging markets in particular and all sectors in general.
As mentioned above, your diversified asset allocation is a personal allocation based upon your investment goals and objectives, time horizon, and your risk tolerance. Your allocation should be confirmed at least once a year or when your personal circumstances change leaving you with questions about your long-term financial goals and objectives.
Rebalancing
Diversifying reduces risk in the portfolio by investing across multiple sectors. Rebalancing removes the temptation of trying to time the market and keeps the portfolio aligned to your goals. To keep your diversified asset allocation on track you must have periodic portfolio checkups and, at least annually, rebalance. Rebalancing your portfolio ensures movements in the market, either up and down, do not move your portfolio away from the target allocation and expose you to more risk. In short, rebalancing sells off some of your winners which are over weighted in your portfolio and buys sectors that have gone down and are now under weighted.
Over the next 30 days, we will be examining portfolios and executing rebalancing to bring your portfolio back in line with your target asset allocation.
Investing is a long term, ongoing process. Working together, we have created a plan and chosen appropriate investments at appropriate allocations. No one knows how 2015 will play out. Last year’s top sector, Real Estate Investment Trusts (REITs), may be the worst performing sector in 2015. Again, no one knows. But, we do know this: your diversified portfolio helps you manage risk, exposes you to investments across multiple assets and multiple sectors, and, with rebalancing, maintains your risk level over time.
We at The Nalls Sherbakoff Group are looking forward to the New Year and wish the very best to you and your family in 2015.