Diversification is Still Better for Long-Term Investors

(November 4, 2013) — The recent volatility shocks experienced by institutional investors must not deter them from the diversification theory, as performance will return, according to SEI.

The report entitled “When Diversification ‘Fails,’ and Why We Still Believe,” said short-term performance is just noise—a distraction that tempts investors to ignore their long-term goals.

The phenomenon was particularly true for 2013, the report said. The S&P 500, an index most investors consider to be a barometer of market performance, outperformed most asset classes with a total return of almost 20% year-to-date.

However, SEI asserted that it is significant for investors to understand that US large-cap stocks are subject to market volatility and fluctuations in performance like other asset classes.

“With perfect foresight, investors could simply allocate all of their money to the best-performing asset class each year,” the report said. “Absent this divine ability, however, the next best option is to invest in a variety of assets that react differently to a variety of market forces.”

If possible, investors should focus on searching for new asset classes. “If investment professionals are able to find sound strategies that provide different exposures than the assets already contained in a typical portfolio, they may be able to blend that strategy with those other well-known assets to create a more robust portfolio,” the report said.

This is difficult to do, SEI said, for two reasons: identifying good exposures is one of the hardest facets of investing, and understanding exposure is “inherently new” to investors. The unfamiliarity could cause investors to believe short-term underperformance from market volatility is sign of trouble and abort. Investors should instead understand that deviations in performance are a basis of diversification.

So how can investors avoid as much short-term volatility as possible?

SEI suggested adjusting the time or the holding period of a certain asset class could do the trick. “The longer an investor allocates to the better investment, the lower the impact of volatility on the returns and the more likely that investor is to outperform as expected,” the report said.

A capable investment manager could also find uncorrelated assets to blend with a portfolio—a strategy SEI dubbed “the Holy Grail of finance.” This strategy would likely increase the expected return while reducing expected risk.