The Benefits of Diversification – Part 2

By Schultz Collins Investment Counsel on August 30, 2022

In Part 2 of our presentation on the Benefits of Diversification, we continue the dialogue through a series of slides that examines different parts of the global stock market, and how to gauge the level of exposure that is appropriate.

Let’s pick up the presentation on slide 8, which continues the dialogue of the benefits of diversification through a series of slides that examines different parts of the global stock market, and how to gauge the level of exposure that’s appropriate. 

Data provided by Morningstar. For illustrative purposes only. 

The chart on the top right indicates long term growth of $1,000 for four major asset class indices: Large Cap Growth, Large Cap Value, Small Cap Growth and Small Cap Value. As the chart indicates, the greatest amount of wealth has been achieved by investors in large cap value and small cap value stocks. Naturally, any investor would be enticed by this data to invest heavily in these areas of the market. However, the left side of the page provides additional insight on the risk associated with these different asset classes. Here we show 10-year rolling periods of returns. Returns in red indicate rolling 10-year periods where value stocks underperformed growth stocks, illustrating the risk that value stocks can underperform over longer periods of time. Higher returns are not free, the cost is higher risk. 

The S&P 500 index of U.S. stocks has outperformed 30-day U.S. Treasury Bills by 5.86% from 1964 to 2021, so many investors expect returns from stocks to exceed those from bonds over very long periods of time. However, as seen in the slide titled The Market Premium below, investors should not expect this outperformance to occur year in and year out.  

Data provided by Morningstar. For illustrative purposes only. 

The blue bars represent years in which the S&P 500 outperformed T-Bills. The red bars represent years in which the S&P 500 underperformed T-Bills. For example, on the far left, you can see that in 1964, stocks outperformed T-bills by more than 10%, but only two years later, stocks underperformed T-Bills by more than 10%. While an investor may conclude that stocks are an integral part of their portfolio, as this data indicates, stock performance is uncertain and cannot be relied upon to produce positive returns every single year. 

Academic evidence has shown there are types of stocks that may produce excess returns when compared to the broad stock market. First, we will discuss what is called the Size Premium, as seen below, which is the historic extra return produced by small cap stocks vs. large cap stocks. 

Data provided by Morningstar. For illustrative purposes only. 

In this slide, we see that small cap stocks produced an extra return of 2.37% vs. large cap stocks from 1964 to 2021. As we saw in The Market Premium slide, this extra return doesn’t consistently show itself. The blue bars represent years where small cap stocks outperformed large cap stocks. The red bars represent years where small cap stocks did not outperform large cap stocks. You will notice the size premium’s outperformance and underperformance can span many years, and small cap stocks generated higher returns just 62% of the time.  

Second, we will touch on what is called the Value Premium, as presented here, which is the historic extra return produced by value stocks vs. growth stocks. 

Data provided by Morningstar. For illustrative purposes only. 

In this slide, we see that value stocks produced an extra return of 0.94% vs. growth stocks from 1964 to 2021. As we saw in the Size Premium slide, this extra return is not dependable year in and year out either. The blue bars represent years where value stocks outperformed growth stocks. The red bars represent years in which they do not and by what degree. You will notice the value premium’s outperformance and underperformance can span many years, just like small cap stocks. It’s important for the investor to realize that value stocks have outperformed growth stocks just 55% of the time. 

Finally, we examine the potential combination of international and U.S. stocks, as referenced below. 

Data provided by Morningstar. For illustrative purposes only. 

The blue bars represent the amount of outperformance of international stocks vs. U.S. stocks. The red bars indicate the opposite and by how much. Over long periods of time, data indicates that international stocks have actually underperformed U.S. stocks about 55% of the time, and have generated a lower rate of return than U.S. stocks. Just like we saw in small cap and value stocks, there are long periods of time of outperformance by either market. As a reminder, and as illustrated in Part 1 of this presentation, the addition of international stocks to a portfolio may reduce its risk. Moreover, owning international stocks increases the investor’s opportunity set for positive stock returns, since more than half of all publicly traded companies are outside the U.S. 

There are various parts of the global stock market that investors should consider during the portfolio construction process. Whether it be small cap stocks, value stocks or international stocks, investors should work with an advisor to carefully weigh the risk and return data of each in relation to the goals of the portfolio and the investor’s risk preferences. 

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