November 25, 2023

U.S. equities rose for a fourth week in shortened holiday trading through the close on Friday, November 24th.  The S&P 500 Index gained 1.0%, advancing to its highest level since August.  30-year Treasury yield ended Thanksgiving week higher, snapping four weeks of declines.

A key factor that’s been driving the stock market’s rally in recent weeks is the belief that the Federal Reserve is done with interest-rate hikes.  Although minutes of the recent Fed meeting suggest that monetary policy will remain at current levels, recent economic data suggests that inflation is still trending down, which in turn may lay the groundwork for expecting rate cuts at some point next year.

Diversified portfolios have been unable to keep pace with the S&P 500 this year, as the widely followed index has benefited greatly from a red-hot year for big-tech stocks.

Portfolio diversification involves investing in various asset classes, market sectors, and other categories to manage risk and limit potential losses.  The goal is to reduce the negative impact declining investments have on a portfolio’s aggregate value by offsetting some or all of those declines with investments that are performing well.  

History has shown that over the long term a diversified portfolio has the potential to generate more stable returns, which in turn can make it easier to maintain the course during turbulent markets, and thereby improve the odds of hitting your investment targets.  For instance, here is a chart Morningstar created comparing the performance of large cap stocks (this and last year’s big winner) to mid-cap and small-cap stocks since 1994. 

And here is a comparison of the risk of loss over time between the S&P 500 and a portfolio that is divided equally between large-cap, mid-cap and small-cap stocks.

In short, if history is our guide, then it’s fair to say that diversification lowers risk and improves the odds of investing successfully.  But as the last two years have clearly demonstrated, diversification is not a fail-safe strategy.  To the contrary, when market gains are highly concentrated in one or two sectors, diversification can leave investors disappointed, and in the market (pardon the pun) for a different approach. 

One of the key reasons diversified portfolios (including those of our clients) have underperformed their benchmarks lately has been the unprecedented concentration of stock market gains in a handful of stocks.  For example, the S&P 500 is up 18.8% this year, but if you were to remove Apple, Microsoft, Google, Facebook, Amazon, Nvidia, and Tesla from that index, the remaining 493 stocks would be essentially flat in 2023.

Making things even tougher has been the historic plummeting of bond prices, which have fallen by about -12% since the start of 2022.  Fortunately, the decision we made back in 2021 to lower exposure to longer term bonds – which have suffered the brunt of the bond market’s losses -- has helped to reduce the impact of falling prices for fixed-income securities on our client’s portfolios.

So, has diversification’s day come and gone?  I don’t think so.  While diversification does not eliminate the potential for long periods of underperformance, I have little doubt that it does reduce the likelihood of that happening.   If you would like to learn more about the pros and cons of diversification, I recommend this article by Nick Maggiulli. 

That’s all for now.  Have a great weekend, and invest wisely my friends.