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Resolve to Not Make This Investing Mistake in 2017

Brent Schutte, CFA •  December 27, 2016 | Your Finances

Brent Shutte, CFAAs another year draws to an end, it’s time to reflect upon the past and look toward the future. Many investors spend their time fixating solely on the recent past to inform their view about what’s yet to come. While historical analysis can be a helpful investing tool, eventually all trends end. Unfortunately, this often occurs right about the time investors fully embrace yesterday’s news and are compelled to take aggressive actions.

I worry that we have again arrived at a time when investors are becoming convinced that recent short-term trends are morphing into actionable long-term performance-enhancing truisms. I encourage investors to make a New Year’s resolution to avoid using past performance as an excuse to abandon diversification and concentrate their portfolios on recent “winners.”

Diversification is a buzz word that investors have been taught they should desire. When I’m speaking to a group of investors and I ask for a show of hands in favor of diversification, every arm goes skyward. But the reality is that when investors actually have diversification, they often hate it. Why? Because diversification means you own assets that provide sub-par performance, perhaps for years. Eventually human nature drives investors to wrongly rid their portfolios of these perennial laggards in an attempt to improve their future returns.

I am not suggesting that you shouldn’t sell underperformers or change your allocations. But overweights and underweights to asset classes should be done within a context of a long-term, focused, broadly diversified asset allocation.

Be Careful Chasing the Latest Hot Trend

Predictions can be fallible. Yes, one could say I am beating up on my own profession, but extreme trend calls often fall flat. I recently had a good chuckle that peak oil demand—the idea that demand for oil has peaked and will only fall in the future—is morphing into the new wisdom in the oil market to justify lower future oil prices. Is peak oil demand real? Only time will tell.

But history suggests that bold predictions don’t always hold true. In the late 1990s a barrel of oil was priced in the low teens and, according to many “expert” predictions, was headed to the single digits because the U.S. had become energy efficient. This trend ended after China (remember this old investment favorite?) burst on the scene in the early part of the century and stretched oil’s existing infrastructure to its limits. The result was that oil skyrocketed to a per-barrel cost near $150, causing many to point to peak oil supply—the idea that world could not continue to increase daily production of oil to meet demand—as justification for the rally to continue into the $300s. The collapse to a low of $26 per barrel earlier this year shows how trends come and go.

Investing for You: 5 Critical Questions for a Smart StrategyWhile the oil narrative is interesting, I have bigger concerns with regard to the current time period. Notably, today’s international versus U.S. equities trend reminds me of another known wisdom that captivated many investors in the late ʼ90s. Much like today, U.S. stocks had outperformed other asset classes for an extended period of time, thus convincing many investors that their path to future success was incumbent upon removing the other asset classes and avoiding “diversification for diversification’s sake.”

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In late 2000, the S&P 500 (U.S. Large Cap Stocks) completed a strong period of returns relative to other markets. From June 30, 1994, until Aug. 31, 2000, the S&P 500 returned a cumulative 213 percent more than International Developed stocks and 283 percent more than Emerging-Market equities. By the year 2000, to say that many investors had tired of hearing the old-fashioned diversification theme as a reason to stay in international equities was an understatement.

What happened next? From Aug. 31, 2000, to Oct. 31, 2007, the S&P 500 returned 1.99 percent per year, while International Developed advanced 8.26 percent per year and Emerging Markets roared ahead by 20.56 percent annually. Not surprisingly, this caused investors who missed the first trend change to finally return to international markets (especially China and Emerging Markets) around 2006-2007, right about the time this trend ended. 

Here we sit, many years later, and once again the U.S. equity markets are outperforming. Questions about the wisdom of diversification are once again filling my inbox. I’ve heard claims from individual investors that they outperform professional investors. Without satisfying my natural desire for an audit, my response is yes, this is absolutely possible, especially in the short term. After all, those who concentrated their money in U.S. tech stocks back in the late 1990s had an exhilarating run for a few years. Unfortunately those years of returns melted away very abruptly for individual investors who decided to abandon diversification and concentrate in U.S. tech stocks. Professional investors often win longer term simply because their investment process keeps them from making big mistakes like abandoning diversification.

As we look ahead to 2017, we worry that the fear of rising interest rates may cause many investors to contemplate abandoning bonds. Please remind yourselves of the reason you own this asset class—for income and a hedge against other parts of your portfolio—before making that decision.

Twenty-plus years of watching market trends and vast sentiment shifts have taught me that remaining centered is a strong foundation for long-term success. Diversification doesn’t matter until it does, and then you’ll be thankful that you have it. In other words, its payment stream is not constant; but when it pays, it often more than makes up for its past shortfalls. So if you make a New Year’s resolution, let it be to resist the temptation of trends over the proven merits of diversification.

Happy New Year!

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) (life and disability insurance, annuities, and life insurance with long-term care benefits) and its subsidiaries. Northwestern Mutual Investment Services, LLC (securities), subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC. Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI (fiduciary and fee-based financial planning services), subsidiary of NM, limited purpose federal savings bank.

This publication is not intended as legal or tax advice. Financial representatives do not give legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor. 

The opinions expressed are those of Northwestern Mutual as of the date stated on this publication and are subject to change. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources. Sources may include Bloomberg, Morningstar, FactSet and Standard & Poor’s.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.

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