Is diversification ineffective?

In 2021, the US stock market (both the S&P 500 and the Dow Jones Industrial Average) returned over 20% (28.7% and 20.1% respectively); these are solely made up of large capitalization US stocks. If you also had some mid-cap and small-cap stocks in your portfolio, you did a lot worse (the Russell 2000 was up 14.8% in 2021). Even worse still were international stocks: developed international stocks (per the MSCI-EAFE index) were up 11.3%, but emerging markets (per the MSCI-EM index) had a negative return of -2.5%. And, those with bonds in their portfolio are lamenting that in 2021 as the Bloomberg US Aggregate was also down -1.5%.

To make matters worse, a lot of this performance separation happened in the last 6 months of the year, meaning that a diversified portfolio may have even lost money from July to December, while the ‘stock market’ was up 10% during the same timeframe! All of this could lead one to think that the best way to invest is by putting 100% into an S&P 500 index fund. I’m here to tell you: diversification is NOT ineffective.

Investing is best viewed in the long-term, and also best viewed in light of cyclicality, currency, and inflation. Throw in Covid-19 and the resulting restrictions, making investing even more complicated in the short term.

One example of the above: while we saw an 11.3% return in developed international stocks, those in Europe and the UK gained over 20% locally on the same investments. Why? Because the US dollar has been strong, depressing foreign returns for US investors. It appears that the dollar is now expensive, so a weakening dollar (which will happen sooner than later) will be good for diversified US investors as, at some point, it will enhance international investment returns.

If you want to dive deeper, this chart is a great visual showing 20 years of returns (ending 2020 as the numbers for 2021 haven’t been updated yet) for various asset classes; oddly enough, real estate performed the best overall for that period of time (and will continue to be on top once the chart updates with 2021 numbers, by the way). Another interesting note, among many: in 2018, cash was the best performing asset!

The point here is that betting on one asset class is NOT the way to go. Hence, diversification (and rebalancing) is the way to maximize returns in the long run. Hindsight is 20/20, but shortsightedness is definitely not. So, stay diversified!

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