Modern Portfolio Theory was developed by Nobel Prize winning economists between the 1950s and 1970s. The theory espouses mathematical ways to construct portfolios by balancing the use of uncorrelated assets to diversify risk and enhance returns. However, we have learned over the last two years that having a diversified portfolio does not automatically mean investors will outperform or gain value in risk reduction. Most segments of global financial markets failed to keep pace with many of the popular domestic stock market indexes.
Should we abandon the notion of diversification and just invest in large cap stocks or the S&P 500? It is worth noting that over the past 20 years the S&P 500 was the worst asset class 25% of the time. Although the formulaic approach to asset allocation has not worked in recent years, we still believe in the benefits of diversification. How and why should we diversify? How we diversify is by assembling a combination of investments that display different and uncorrelated return behaviors. The reason why we do it is to offer a more stable and consistent pattern of returns.
The last couple of years have been particularly challenging and the low level of volatility may a major factor. By using the level of the VIX (an index that demonstrates the market’s expectation of 30 day volatility) as a proxy for volatility, when readings have been high (above 24), a diversified portfolio has outperformed the market 88% of the time by an average of 5.7%. When volatility is low (below 15%), diversified investments have trailed the S&P 500 by almost 5%. Higher volatility presents more return disparities among investments and thus potentially outsized return opportunities from diversification. Also, during periods of high volatility, investors want to mitigate risk and look for other avenues for investment.
The benefits of diversifying through capitalization (large versus small), style (value versus growth), and region (US versus global) have waned somewhat as these asset classes have become more correlated and volatility has been low. Diversification through alternative investments (long/short, global macro, managed futures, master limited partnerships) represent new tools for diversifying risk and stabilizing returns. Tactical strategies (overweighting sectors, direction of interest rates, foreign currencies), should also be considered.
Diversification, along with patience and commitment to a financial plan, remains an important weapon to manage volatile and uncertain market conditions.
John Hess 
Falgun Jariwala 
Managing Principal Managing Director
jhess@nsinvestors.com fjariwala@nsinvestors.com
www.nsinvestors.com www.nsinvestors.com
- The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you consult your financial advisor.
- All performance referenced is historical and is no guarantee of future results.
- All indices are unmanaged and may not be invested into directly.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Stock investing involves risk including loss of principal.
1. Data available on U.S. Census Bureau website:https://www.census.gov/construction/nrs/new_vs_existing.html