100% in the 500?

We’ve been getting several thoughtful questions from clients that are along the lines of: Since the S&P 500 has been outperforming all other indexes over the past few years, why should I invest in anything else but large company stocks?

Certainly when I look at results over the past three years, it‘s difficult to justify investing in anything else but large company stocks. Between 2012 and 2014, the S&P 500 earned 20% per year, small company stocks earned 19%, real estate 15%, developed international 11%, emerging markets 4%, bonds 3%, and cash 0%. When confronted by these questions in the past, I typically say diversification is very important, we need to analyze investment decisions over a long-term time horizon, and during short one or three year periods, any one investment might have unusually good or bad performance. However, the problem is when I look at returns over the past 30 years, the results do not bode well for diversification:

Annual Returns between 1985 and 2014:

Why are the long-term results (and short-term results) so favorable for S&P 500? Because we’ve just come through a five-year period in which the S&P performed so incredibly that it blew away all other investments. The U.S. economy, and U.S. stock market, has been in full recovery mode, while overseas markets were more sluggish. U.S. stocks outperformed developed international stocks by an average of 10% per year over the past five years. Such extreme performance affects short-term and long-term statistics. Indeed, those five year performance numbers for U.S. stocks are the best since the late 1990s.

And that brings me to my point about why investors should diversify. Let’s look at what happened the last time the S&P 500 was so dominant – the late 1990s. Even back then, I was preaching the ideals of diversification, and was being chided by some as being too conservative. Large cap stocks had enjoyed their best five year growth ever, and many investors believed, as some do now, that they should put all of their eggs in the S&P 500 basket. And here is what happened over the next 10 years:

Annual Returns between 2000 and 2009:

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Over the decade of the “00”s, the S&P 500 underperformed EVERY other investment, even cash! Five years ago, investors weren’t asking why they shouldn’t put all of their money in large company stocks – they were asking why they should put ANY of their money in large company stocks. That’s why diversification is important. We simply can’t predict swings in the market – and diversification into investments like international and emerging market stocks can significantly reduce the risk of a portfolio.

I’m not predicting a dire outcome for the market over the next 10 years – indeed, if you read our commentaries on our website, it’s clear we’re moderately bullish on U.S. stocks. Nor am I suggesting that you shouldn’t invest large amounts of your portfolio in the S&P 500. But some diversification into other investments is vital to control your overall risk. To summarize:

• The run up in the S&P 500 over the past five years has made many investors question the need for diversification

• There have been long stretches of time, as recently as the past decade, when the S&P 500 has significantly underperformed other types of investment

• We believe the best solution is to broadly diversify an investment portfolio to reduce potential portfolio volatility

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