By FPA member Eric S. Toya, CFP®
Last Updated: February 6, 2012
If you invest according to the advice of most financial experts, your stock portfolio is a well diversified mix of stocks from the U.S. and abroad, both big and small companies and a mix of growth and value. The idea behind this sort of diversification is to open your portfolio up to opportunities anywhere around the world rather than limiting your portfolio to U.S. companies. Also, most foreign markets don’t move in lockstep with U.S. stocks. This means that as one zigs, the other may zag, which can reduce the overall volatility in your portfolio.
Looking back on the market returns from 2011, it is easy for investors to question the validity of this strategy. The S&P 5001 index of large U.S. companies finished the year with a small gain of 2.11 percent. Almost everywhere else you looked in the universe of stocks, it was a very different story. Small Cap U.S. stocks, represented by the Russell 2000 index, were down 4.18 percent. Even worse, foreign stocks generally had double digit losses.
With all this you may be asking, why don’t I just stick to the safety of big U.S. companies and own the S&P 500?
It’s true that the S&P 500 would have beaten most other categories of stocks in 2011, but looking over a longer period of time, you can see that diversification can greatly benefit your results.
A strategy of diversification worked out better for investors during the period commonly referred to as the “lost decade.” Over the 10 year period from January 2000 to December 2009, an investor in the S&P 500 index of large U.S. companies ended the period with a total loss of 9.10 percent. However, a more diversified portfolio fared quite a bit better. For example, the Russell 2000 index of small U.S. stocks gained 41.23 percent over the same period (3.51 percent annualized), the MSCI EAFE index of large foreign companies was up 12.38 percent (1.17 percent annualized), and impressively, the MSCI Emerging Markets Index returned 154.28 percent (9.78 percent annualized).
All told, through the “lost decade” an investor with small cap and international stocks generally finished with a positive return2 rather than the negative return for stocks generally cited in news reports. The lesson here is that there will be times when large U.S. companies lead all other major equity categories. However, that is not a reason to jump ship on a sound portfolio diversification strategy.
FPA member Eric S. Toya, CFP®, is Vice President of Wealth Management for Trovena, LLC in Redondo Beach, Calif. Eric graduated from the University of Southern California with a BS in Finance and Accounting. Eric has been quoted in national publications, including The Wall Street Journal, Money Magazine and the Los Angeles Times.
1 The S&P 500 and other indices mentioned here are not available for direct investment and performance does not reflect expenses of an actual portfolio. Past performance is not a guarantee of future results.
2 Actual returns depend on the actual allocation, as well as portfolio expenses. However, as an example, a portfolio that consisted of 25 percent S&P 500, 25 percent Russell 2000, 20 percent MSCI EAFE, 20 percent MSCI EAFE Small Cap and 10 percent MSCI Emerging Markets Index finished the decade with a total return of 40.03 percent (3.42 percent annualized).