Coaching clients in moments that matter: 4 enduring diversification principles

With rising interest rates over the past two-and-a-half years causing losses across most balanced, diversified portfolios (even for the most conservative allocations), combined with high inflation, many have called into question the entire concept of diversification. As we have previously discussed, these conditions are Advisor's Alpha® weather and diversification matters more than ever. The Investment Advisory Research Center has developed a video, Diversification has rewarded patience to explore the four core principles of diversification with your clients and help them navigate the always uncertain markets.

The full video is at the bottom of the page. Simply right-click and save it to send to clients.

Key insight 1: Diversification is not dead

But diversification remains quite commonly misunderstood: At its core, it’s just a simple mathematical concept of combining asset classes, since you can’t see into the future and determine the top performers ahead of time. Where do you want to be within the corridor of returns? For a diversified portfolio that does not engage in a high level of market timing, more than 90% of long-term outcomes are determined by the breakdown of the portfolio between stocks, bonds, and cash. A diversified portfolio won’t finish at the bottom or top of the annual performance derby, and we don’t even know if it’ll finish positive in any given year. But it will perform as intended, which is somewhere in the middle to above the middle of the asset-class pack.

So, focus on what is in your control, which is the exposure to risk, and how you and your clients react when the “unexpected” inevitably happens. Also keep in mind that diversification is not just the classic 60/40 of 60% equities and 40% fixed income. Further, all the headlines recently around the 60/40 portfolio miss the main point—which is that the right allocation can be any allocation along the spectrum, from 100% bonds to 100% stocks; with the most suitable mix being dependent on each client’s goals, objectives, risk tolerances, and time horizon. Then, once the allocation is suitable, being broadly diversified, maintaining low costs, and “staying the course” are critical.

How to use the video with clients: Draw your clients’ attention to the width of the shaded corridor or the distance between the highest and lowest dot in any given year and note how the 60/40 portfolio always falls within that range. Make clear that the 60/40 is simply a proxy for diversification and that their specific portfolio may be higher or lower within—but never outside—the range of returns for the underlying asset classes. And emphasize how this shows diversification doing exactly what it’s meant to do. The diversified portfolio reaps some of the benefit of winning investments and helps mitigate the risk of the losing ones over time.

The 60/40 portfolio (white line) always falls within the range of returns defined by individual asset classes.

Key insight 2: Diversification is not a set it and forget process, but requires action and attention

Staying the course does not mean staying still. It requires discipline and courage to stick to the asset allocation. You have to rebalance, and this requires being world class at behavioral coaching, given how counterintuitive rebalancing and staying the course are.

How to use with clients: Emphasize that while your clients may see a smooth line on the chart representing the diversified portfolio, diversification is a strategy that requires constant monitoring and occasional rebalancing to ensure that the portfolio is still invested in the correct proportions. Additionally, remind your clients of the value that you can add (and have) as a behavioral coach.

Key insight 3: Expect the unexpected—cyclicality is not cyclical

Given a long enough time horizon, conditions could be better or worse than your investors have experienced in the past. Focus on perspective. Some investors may have been through multiple downturns already, while others may be experiencing their first. With the benefit of hindsight, your clients can be better prepared for the unexpected.

How to use the video with clients: Emphasize to your clients that as the time lapse runs, you begin to see that with longer time horizons, the 5- 7-, and 10-year horizons have much less dispersion (that is, from lowest to highest) than the shorter time horizons. For those investors who have shorter time-horizon goals to plan for, notice that the dots for more conservative investments, particularly cash, do not fluctuate much even in the 1- and 3-year periods.

It can help to have a longer time horizon, since dispersion diminishes over time.

Key insight 4: Portfolio returns are important, but client goals matter most

Remind your clients of the “why” behind their investment strategy and focus on whether they are still on track to meet those goals. These are the “percents” that clients care most about. Put another way, a 20% market downturn does not mean a 20% decrease in ability to reach those goals.

How to use the video with clients: You spent a lot of time and effort up front designing the portfolio to implement your clients’ financial plans. Remind them why they are investing in the first place and show that over longer time-horizons, negative performance is often followed by positive performance. Conversely, abandoning the well-thought-out plan, especially during volatile periods, is a surefire way to impair your clients’ abilities to reach their goals.

Remind clients to focus on long-term goals rather than short-term returns.

Patience and diversification can help to control risk

The video below illustrates all of these diversification insights at once, allowing you to give clients a comprehensive perspective on this often-misunderstood investing concept.

Additional resources:

Putting a value on your value: Quantifying Advisor's Alpha

Managing market volatility for your clients and your practice

Find out how model portfolios can benefit you and your clients

The case for Vanguard strategic models: Good for your clients, good for your practice

Behavioral Coaching Toolkit

Portfolio Analytics Tool

Notes:

Asset classes are represented by corresponding indexes as follows. Cash: FTSE 3-month US T-Bill Index, REITs: MSCI US REIT Index, U.S. Equities: Russell 1000 Index, global equities: FTSE Global All-Cap Index, emerging market (EM) equities: FTSE Emerging Index, commodities: Bloomberg Commodity Index, U.S. Treasuries: Bloomberg US Government Index, U.S. corporate bonds: Bloomberg US Credit Index, global bonds: Bloomberg Global Aggregate ex USD Index, high yield bonds: Bloomberg US Corporate High-Yield Index, EM bonds: JP Morgan Emerging Market Bond Index, 60/40: 60% Russel 100 Index, 40% Bloomberg US Aggregate Index. Date range is January 1, 1992, through December 31, 2022.

• All investing is subject to risk, including the possible loss of the money you invest.
• Diversification does not ensure a profit or protect against a loss.
• Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments. Investments in bonds are subject to interest rate, credit, and inflation risk.
• High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings.
• Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
• Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
• U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.