Let's Talk Diversification

Let’s talk about diversification at this year-end.

The S&P 500 returned 17.9% from 2009-2013 and will extend its streak if 2014 closes out near where it is now. Similarly, in the late 90’s the tech stock boom took the US large growth category of the stock market to unprecedented highs. Growth stocks did not go up to the exclusion of other categories, but no other category generated similar returns. Consider this comparison of the compounded annual return to the small cap category:

Category                                 1995-2000 Compounded Return

Large Cap Growth                   30.3%                         

Small Cap                                19.0%                         

In particular, small cap returned -3.3% in 1999 and the media and investing public spurned them.

In 2000 the story was the tech stock boom and the story of the day was Cisco, Lucent, Microsoft and other big growth names. Five years later, and examining the full 10 years from 1995-2005:

Category                                 2000-2005                   1995-2005

Large Cap Growth                   -4.1%                           11.8%

Small Cap                                16.5%                          17.8%

I bring this up because the striking returns of the S&P 500 in the last few years may cause some to question the need for diversification. Maybe a better question is ‘who predicted the S&P would have this kind of future after the 2008 decline’. We never know in advance how stocks will perform in the short term but I know what we would do in this circumstance. In the above scenario, we would have been a net seller of growth stocks by 2000 and a net buyer of small cap. Our diversified portfolio target proportions would have caused us to rebalance away from the expensive thing and towards the cheaper thing.