For nearly a year now, we have been writing about the extended length of the current business cycle. We have been slowly positioning our portfolios into a more defensive mode in anticipation of a looming economic slowdown. The US economy has indeed begun to show signs of losing steam. We’ve seen weaker data in housing, business confidence and capital spending. Most notable is the data from the manufacturing sector — the “PMI” — which has dropped to its worst level since 2009. The softening economic data notwithstanding, financial markets have continued to rally.
A key reason for the market’s resilience is the decline in interest rates, driving large investors to buy stocks. After all, if given a choice of bonds in a low interest environment, or stocks with a dividend yield and capital appreciation potential, they usually pick stocks. However, the big picture is this: low rates reflect a slowing, not a booming economy.
Despite ClearRock’s increasingly defensive posture, our portfolios are still participating in the upside of the 2019 US stock market rally. Why?
The simple answer is “diversification.” Our core investment philosophy embraces the adage of never putting all your eggs in one basket. In a financial world that has become increasingly complicated, we believe that nothing will ever replace the simple notion of diversifying your money across different types of assets.
The dual dynamics of “defense” and “diversification” can indeed work in harmony, driving long-term growth of one’s portfolio during all types of markets and at every stage of the business cycle.
The chart below tells the story:
What is not necessarily intuitive when looking at the growth of the two hypothetical portfolios in the chart is why the diversified portfolio performed better than the all-stock portfolio.
The Answer is “Good Math.”
During the most volatile periods in this example, the 2000 Dot.com Bubble and the 2007-2009 Great Recession, the US stock market dropped precipitously. The 100% stock portfolio suffered losses of 45% and 51% respectively during those two periods. For those portfolios to regain their pre-crash balances, they had to appreciate much more in percentage terms than the losses they suffered.
Consider this example: when something declines from 100 to 50, it has lost 50% of its value. But for that same investment to regain that loss, it now must appreciate 100%.
In our chart, the all-stock portfolio that lost 51% of its value during the Great Recession had to recover its losses by appreciating nearly 100% over 53 months. The diversified portfolio which lost 31% during that period needed to appreciate 45%, which took just 36 months.
Big Losses are Hard to Recoup.
There are few times in history when markets appreciate without some volatility along the way. This is why diversification can be extremely helpful.
If one is confident that markets will go up with no volatility along the way, then buying an all-stock portfolio is the best way to invest. History has proven otherwise. Staying diversified throughout all kinds of markets and cycles is the best way to accumulate wealth over the long run.
Let good math be your friend.
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Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. There can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter (article) serves as the receipt of, or as a substitute for, personalized investment advice from ClearRock Capital, LLC.
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