As stocks start off another year with a bang and popularity of speculative investments have captured the public’s imagination, it’s an opportune time to remind clients of the importance of diversification. At Cardinal, we strive to help our clients achieve their long-term financial goals. Essential to this aim is maintaining a properly diversified portfolio based on each clients’ individual time horizon and risk profile which allows clients to remain confidently invested over the longer-term.
Diversification has often been called the only free lunch in investing. The basic argument in favor of diversification still applies. A diversified portfolio reduces volatility, limits losses during periods of heightened market volatility, and provides a place to go for cash without turning temporary unrealized losses into permanent realized losses. In addition, there are quantitative tools we apply that enable very well calibrated means of managing that diversification to optimize the recognized trade off between risk and return for the investor beyond simple, broadly defined, diversification. While the COVID-19 bear market in early 2020 was unusually swift and severe, basic portfolio diversification helped buffer some of the losses. The overall equity market dropped 34.5% from February 19 through March 23, 2020, but high-quality fixed-income holdings held up well. Cardinal’s equity portfolios, which are constructed to exclude roughly 20% of the relevant equity markets’ risks, held up better than the broad equity markets we benchmark against. As a result, a portfolio mix of Cardinal’s carefully selected stocks and bonds preserved capital far better than a simple construction of equity and bond index portfolios during the market downdraft.
Within a portfolio there are many potential combinations of U.S. large and small company stocks, non-US stocks, fixed income securities and cash. Each combination entails different levels of risk and return expectations. A diversified portfolio of stocks, bonds and cash can be identified to ensure that cash flow needs are met while allowing longer-term historical market returns to work in your favor. While near-term returns are highly unpredictable, over the long-term, market history suggests that returns are positive. Broadly diversified portfolios have historically held up better because they do not decline as much in periods of volatility, and provide various sources of cash as needed, while enjoying years of appreciation. Proper asset allocation provides the necessary volatility reduction and liquidity to permit time diversification to work in your favor.
Holding a diversified portfolio helps to expand the opportunity set and ensure that you don’t miss out on areas that can enhance long-term returns. Currently international stocks provide a prime example. There are more publicly listed companies outside the U.S. than within. This presents an expanded universe of companies in which to invest. Furthermore, while many U.S. companies’ valuations have soared over the trailing twelve months, many international companies are still excellent values. International companies may also soon enjoy a competitive advantage over U.S. domiciled companies due to proposed higher corporate tax rates. The combination of expanded opportunity set, lower tax rates, and lower valuations seems to favor including international diversification. We view international stocks as an indispensable component of healthy portfolio construction.
Finally, alternative investments often come with the caveat that they are not suitable for all clients. This is an understatement in our view. Over the years our experience has taught us that alternatives often are highly illiquid, contain redemption restrictions, lack transparency, less regulatory oversight, sometimes contain enormously concentrated risks, have high management fees, and include unfair profit sharing for the managers of the assets. For these and other reasons, we prefer to avoid such investments. We focus instead on publicly traded securities where the risk-reward tradeoff is manageable via proper asset allocation, disciplined security selection, and optimized transparent diversification.
We continue to wish you good health and encourage you to reach out for any support you may need. Thank you for your trust in Cardinal Capital.