Why diversify your portfolio? Because winners rotate

One of my favourite investment charts over the years is the annually updated “Why Diversify?” poster distributed to financial advisers by Franklin Templeton Investments. It has always found a prominent place on the walls of my work stations or offices.

For the most recent edition, which runs to the end of the 2013 calendar year, the answer to the question “Why Diversify?” is a simple “Because winners rotate.”

When you look at the best and worst performing asset classes in 2013, they are almost the mirror image of the disastrous trough of the global financial crisis in 2008. American equities topped all investments in 2013, with U.S. small caps up 48.14% and U.S. large caps second at 41.27%. Right behind were global small caps, global equities, European equities and foreign equities—all returning between 31.6% and 37.8%. Canadian equities were positive but far less robust, with Canadian large caps returning 13.26% and Canadian small caps 7.76%. And the only losing asset class in 2013 was Canadian bonds, at minus 1.19%.

Now, contrast with 2008: U.S. equities lost 17% (small caps) and 21% (large caps), global equities lost 25%, global small caps lost 28%, Canadian equities lost 31% (large caps) and 46.6% (small caps), European equities lost 32.5%, emerging markets equities lost 41.4%, and BRIC equities lost a whopping 49%.

Now quickly, name the top performing asset class in both 2009 and 2010! It was in fact Canadian small caps both years, up 75% in 2009 and up 38.5% in 2010. Winners indeed rotate, as do losers and Franklin Templeton’s colour-coded chart makes it equally clear that the pattern appears almost totally random and so unpredictable.

The current chart goes back to 1994. It’s instructive to pick one particular asset class and follow its ups and downs over the years. For example, the purple BRIC equities (Brazil, Russia, India and China) were the top asset class in 1996, 1999, 2003, and between 2005 and 2007 inclusive. But BRICs were also rock bottom in 1995, 1998, 2008 and 2011. Meanwhile, U.S. bonds were generally zigging whenever the BRICs were zagging: they were the top asset class in 2000 and 2001, 2008 and 2011, but were at the bottom of the heap in 1996, 2003, 2004, 2006, 2009 and 2012.

The lesson should be clear and is articulated by Franklin Templeton to the side of the poster: “a well-balanced portfolio invested across all asset classes allows investors to participate in the gains of each year’s ‘winners.’” There will, of course, be years when some major losers will be mixed in as well but that’s just the nature of investing in multiple asset classes. Anyone who could predict the top asset classes in advance would invest only in those known winners and soon eclipse both Bill Gates and Warren Buffett in the lists of the world’s wealthiest investors.

Useful as it is to retail investors, the chart, however, doesn’t show every asset class available: just the major stock and fixed-income investments available to mutual fund investors. Two asset classes I’d like to see be included are real estate and gold/precious metals, and hedge-fund fans might like to see some plays on the short side as well.

Jonathan Chevreau is Editor-at-Large at MoneySense. He blogs at findependenceday.com and at moneysense.ca.

About Jonathan Chevreau

As MoneySense’s Investing-Editor-at-Large, he is also author of Findependence Day and co-author of Victory Lap Retirement. Reach him at [email protected], where he is the founder of Financial Independence Hub.

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