Beyond the S&P 500: How to supercharge your diversification

You know you should diversify, so you don’t have all your eggs in one basket. But it’s easy to think you’re getting a lot more diversification than you really are.

In this article, I’ll show you how to use smart diversification to boost your likely long-term results while you reduce your volatility at the same time. Never fear: This doesn’t take a lot of work.

Why diversify at all?

Any single asset, whether it’s a stock or a fund, inevitably has its ups and downs. The “ups” make us feel smart, successful, lucky; but the “downs” can make us feel confused, unlucky, and perhaps even failures.

It helps a lot to own something that’s gaining to offset something else that’s losing.

Prudent diversification

Savvy investors realize it’s just as important to hang on to your money as to make it grow. 

The most reliable way to do this is to own bonds in addition to equities. That discussion is beyond the scope of this article, but you can learn what you need to know in my recent article on this topic. 

Once your overall risk is under control, you’re likely to get the greatest long-term benefit from diversifying your equities.

Timid diversification

When you think of diversification, you may immediately think about owning many stocks instead of just a few. That’s a very good start.

But if all those stocks are pretty similar, having more of them may not help much.

True, owning all 500 stocks in the S&P 500 SPX essentially eliminates the chance that any single corporate disaster will take you down. However, the index is heavily weighted to stocks of giant companies that command relatively high prices. These stocks mostly tend to move up and down together.

Powerful diversification

The best way to boost your long-term returns is to diversify among groups of stocks with different characteristics, and therefore different expected behavior.

I don’t recommend sector funds, but they provide an easy-to-understand example.

Airline stocks often behave differently than retail stocks. Oil stocks behave differently than technology stocks, which are different from banking stocks. And so forth.

If you own just one sector, you’re at the mercy of powerful forces that are hard to anticipate. If you own many sectors, it’s highly likely some of them will always be doing relatively well, beefing up the returns from those that are struggling.

That’s an easy way to grasp the idea of diversification. But a much better way to diversify is among asset classes.

The four major U.S. asset classes are large-cap blend stocks like those in the S&P 500, large-cap value stocks, small-cap blend stocks, and small-cap value stocks.

Each of these is easily and inexpensively available in index funds and exchange-traded funds.

I want to call your attention to a colorful table represents some of the most powerful work we’ve done at the Merriman Financial Education Foundation.

You’ll see year-by-year returns going back to 1928 for each of these four asset classes, along with the results of combining all four into one. That four-part combination is shown in pink; the S&P 500 is shown in green.

If you believe that the S&P is all you need, look at the chart and notice how many times those green boxes landed at the bottom, meaning the index was outperformed by each of the other three asset classes.

Sometimes those years continued…and continued. The S&P 500 was at the bottom for six consecutive years starting in 1940, five consecutive years starting in 1964 and again in 1975, and seven straight years starting in 2000. Plus 16 other individual years. That’s 39 individual years in which owning the S&P 500 was the worst choice among these four asset classes.

In the first years of our current century, after a great run through most of the 1990s, the S&P 500 delivered three money-losing years in a row, driving many disillusioned investors out of the market entirely. When you scan the green boxes at the top of each year, you’ll search in vain for any string of five or more years. Over the 92 years shown in the chart, the S&P 500 was the top performer 26 times and the worst performer 39 times. Ouch.

To stay in the game and capture favorable long-term returns, investors need the comfort and peace of mind that comes from what you can think of as a smooth ride.

Yet, in the period shown in this chart, the return of the S&P 500 switched 34 times from positive to negative, or vice versa.

That is certainly not a recipe for peace of mind.

Since we can never own an investment that will always be the best performer, I want to suggest one that, by definition, can never be the worst, one that won’t jerk you around so much and that will still be profitable over the long haul.

The chart shows such an investment, a four-asset-class combination shown in pink. 

That four-fund combination was smack in the middle of the pack in 72 of the 92 years from 1928 through 2019. That produced considerably less volatility. And since 1928, it outperformed the S&P 500.

If you think all parts of the U.S. stock market generally rise and fall together, you might be startled to see there were 17 individual years in which the spread between the best and worst performing asset classes was more than 30 percentage points. For example,

• In 1967, the spread was 55.1 percentage points;
• In 2001, the difference was 40.2 percentage points;
• In 2003, the difference was 37.4 percentage points.

I’m an unabashed advocate of diversifying away from the S&P 500 with small-cap value stocks. The chart shows one reason: In the majority of years when the spread between top and bottom performers was 30 percentage points or more, small-cap value was on top, the S&P on the bottom.

I do understand that small-cap value stocks aren’t everyone’s cup of tea. But I believe the four-part combination (shown in pink) is a terrific alternative to the S&P 500 by itself. By adding three asset classes, it gave investors a smoother ride, therefore reducing risk, and it made more money.

Since 1928, this four-fund combination’s compound annual growth rate was 11.7%, 1.9 percentage points higher than the 9.8% of the S&P 500.

If that doesn’t sound like a big deal, consider the numbers in the following table.

Table 1: Growth of $10,000

Compound annual growth rate9.8%11.7%After 10 years$25,470$30,237After 20 years$64,870$91,425After 30 years$165,223$276,436Source: Merriman Financial Education Foundation

Over 30 years, that difference boosted the payoff by 67.3%.

Want to know more? Earlier this year, I described seven simple equity portfolios that have outperformed the S&P 500 for more than 50 years.

Richard Buck contributed to this article.

Paul Merriman and Richard Buck are the authors of We’re Talking Millions! 12 Simple Ways to Supercharge Your Retirement. Get your free copy.