Prime time to diversify your investment portfolio

Dec 22, 2016

Diversification is a long-touted investment imperative. And though it may be taken for granted when it does its job well, it meets with intense ire when it falls short of investor expectations.

Such a “failure” most often occurs when some fraction of the market is offering stellar returns. We’ve seen that in recent years when U.S. stocks outpaced most other assets, leaving diversified portfolios with returns below
the S&P 500.

However, history has shown that all bull markets come to an end, but the benefits of diversification are enduring.

Russ Koesterich, Head of Asset Allocation for the BlackRock Global Allocation team, believes diversification is once again gearing up to make a bigger difference in investor portfolios.

Does diversification still work?

I’d argue diversification has always worked. The benefits are simply more obvious over longer time periods. And certainly the benefits of diversification are diluted on a relative basis in an environment where one asset class strongly outperforms. That’s what we’ve had over the past several years: Owning U.S. stocks alone was a winning bet.

But we’re nearing a transition point now. The singular leadership of U.S. equities is unlikely to continue. U.S. stocks are no longer cheap. Markets are differentiating within and across asset classes, and diversification is more important.

What’s behind the transition?

After a seven-year run, U.S. stocks have risen to the point of being expensive, share buybacks are fading, and corporate earnings have not been keeping up with stock price gains.

There are other parts of the world that will likely give you better returns than the U.S. equity market over the next five or 10 years. We see that in places like Japan and some emerging markets.

Based on the current high valuation levels of both U.S. stocks and bonds, expectations for the future returns of a typical U.S. “balanced” portfolio made up of 60% stocks and 40% bonds have never been lower.

U.S. returns: not what they used to be
Return expectations for a U.S. balanced portfolio are at all-time lows

U.S. returns: not what they used to be

Source: Bloomberg. As of Sept. 30, 2016. Indexes are unmanaged and used for illustrative purposes only. It is not possible to invest directly in an index. U.S. balanced portfolio comprises 60% S&P 500 Index and 40% BofA/ML Current 10-Year U.S. Treasury Index. Return expectation is calculated using the earnings yield of the S&P 500 and the 10-year U.S. Treasury yield.

Is 60/40 still the gold standard
of “diversification”?

While a popular standby, 60/40 was never a “one-size-fits-all” benchmark. That is, it was never equally appropriate for every age and risk tolerance.

Perhaps more important than the ratio itself is what’s in that 60/40 allocation of stocks and bonds. Stocks could be concentrated in income-producing defensives or the typically higher-growth, higher-risk tech and biotech sectors. The bond allocation could be Treasuries or it could be emerging markets debt.

Ultimately, what you have in one sleeve has to consider what’s in the other. Diversification is about balancing and offsetting risks, not simply divvying up asset classes.

As an example, consider that bonds today are not serving their traditional roles. They offer no real income and diminishing diversification from equity risk as durations lengthen and correlations rise. As such, they offer less ballast against equity volatility.

We believe very broad diversification — across countries, currencies, and traditional and non-traditional assets — offers the greatest opportunity to mitigate risk.

Is there an advantage in this type of
very broad diversification?

We believe the type of granularity that we target in our portfolio does offer an advantage. We’re in an environment where investors are running out of sources of cheap beta. If most traditional asset classes are expensive and nothing is offering stellar returns, what can you buy?

You probably need to get a bit more esoteric. And that complicates matters. Even if you could do that on your own, you have to consider your comfort in doing it. The low-lying fruit has been picked, and we believe it takes professional and active selection to separate the wheat from the chaff. Also consider that volatility has been quite low and is only likely to rise. Having the flexibility to rebalance, to change the portfolio on a daily basis when needed, is very important in this type of market. It’s something that requires active management, which we believe allows for better risk management.

What is your outlook for volatility?

Volatility has been so low for so long, primarily due to the extraordinary efforts by central banks to prop up economies and incite growth. But we’ve reached the limits of what monetary policy can realistically achieve. With the cushion of policy accommodation removed, we expect there will be some uptick in volatility.

That’s never comfortable. And the farther the fall, the bigger the climb back. You need a 100% return to make up for a loss of 50%. A strategy like Global Allocation is designed to blunt those peaks and valleys, and that tends to keep you in the market.

It’s a slow and steady approach to investment success, and we believe it keeps investors from the risky and rarely fruitful practice of market timing. It keeps you from being your own worst enemy, and has historically offered attractive risk-adjusted returns in the process.


Russ Koesterich, CFA
Head of Asset Allocation for BlackRock’s Global Allocation Fund
Russ is Head of Asset Allocation for BlackRock's Global Allocation Fund. He works with portfolio managers to establish the fund’s macro-level views and also ...