By Dan Ebinger, CFA
Lately, investors love to hate diversification. This is often the reaction when large-cap US stocks, which make up the most watched index−the S&P 500, have done well for an extended period of time. Investors either desire only to own these winners (why own the losers when the winners keep winning?) or feel the need to move to cash and wait for the almost certain downturn. This is precisely the time to stick with diversification.
Undoubtedly, any headline mentioning the current bull market is referring to the performance of the 500 constituent stocks of the S&P 500, which is a microcosm of the global stock market. These stocks (not all of them) have done exceptionally well, leaving other stocks, particularly those overseas in Europe and Asia, in their wake. But there are literally hundreds of markets available to investors and they don’t all perform well at the same time. Maintaining your exposure to the “losers” is hard, especially when the winners seem to keep winning. However, history shows us that today’s losers often become tomorrow’s winners.
If I were writing this in 2009, any reference to a bull market would have been in regard to international and emerging market stocks because it was they, and not the S&P 500, that dominated the performance spectrum over that particular decade (2000 through 2009). In fact, the S&P 500 suffered a cumulative loss over that same time span. However, the relationship completely reversed over the next seven years (2010 through 2017). Those that felt encouraged to only buy the winners (international and emerging market stocks) and avoid the loser (the stocks of the S&P 500) suffered the consequences of that reversal. Those that remained diversified and rebalanced, actually selling the winners and buying the losers, would likely have fared better than those that didn’t. Bull markets tend to make investors forget about the importance of diversification. But, smart investors will stick to their plan. Even if the winners keep winning it doesn’t mean you should abandon the losers. Like insurance, “paying” for diversification feels terrible only when you think you don’t need it.
The other effect bull markets have on investors is they cause anxiety about a likely downturn. People fear the longer a bull market persists, the more likely it is to reverse in the near term. This emotional response leads some investors to react with improper (and sometimes irrational) behavior. It is important to realize that the classification of a bull market has little economic relevance – it is just a way of describing and categorizing market performance. Should it have a material impact on an investment plan? Should it encourage investors to get out of the market? My answer is decidedly “no.”
Unfortunately, not everyone shares that sentiment, so let’s put this current bull market into perspective. A bull market is typically described as a period with increasing share prices and no losses greater than 20% since its last highest peak. I am not sure why 20% is the magic number and not 15% or 10% or 30%. Nonetheless, the S&P 500 has done just that; it has never lost more than 20% since March 9th, 2009 marking it the longest bull market in history. But, it is worth pointing out that the track record of the S&P 500 over that time period hasn’t been flawless. It has dropped more than 10% six times since 2009. It fell 19% in 2011. Only 1% above the negative 20% threshold. That 1% kept the track record going.
However, if the negative 19% had been rounded down to 20%, we would not be in historic territory. In 1990, the S&P 500 dropped 19.9%, which was rounded to a negative 20%. The decision to round stopped the track record on what would have been a bull market running from 1987 through 2000. That thirteen-year bull market would still be the longest in history and another three to four years ahead of today’s “historically long” bull market. A rounding decision is the only reason this bull market is considered historic.
It is important to note that the long-term performance of the S&P 500 did not change because of that rounding decision, only the categorization of its performance as a bull market. Undoubtedly, that categorization changed how investors thought about the market during that time. Would investors feel less concerned about today’s bull market if they knew that it was another three years before hitting historic levels? The fact that a seemingly arbitrary performance categorization, like that of a bull market, can have such a powerful effect on investment decisions is both fascinating and troubling. It points to the importance of removing human emotion from investment decisions and sticking with a disciplined and diversified strategy.
There are periods of time when winners keep winning and bull markets persist. Then, they reverse without warning. It is the nature of investing. No bull market, no matter how extended, should cause investors to lose confidence in the power of diversification and maintaining a long-term perspective. That is our approach – keeping a long-term perspective, appropriately diversifying portfolios, and systematically rebalancing over time, even if it means investing in the short-term losers.