Diversification, Bears & FAANGs

So far, 2022 has been an unforgiving year for many investors, as we’ve been faced with several economic and geopolitical issues. These issues have impacted markets across the globe, which saw the S&P 500 enter bear market territory in June. This volatility is shown in the graph below, which presents the performance of major global financial markets in pound sterling from the beginning of the year until the end of June 2022.

Source: Bloomberg, data from 01/01/2022 – 30/06/2022

The declines seen in both shares and bonds may, on the face of it, appear to question the fundamental reasoning behind diversification, however, you might want to think twice before dismissing the long-term benefits of a well-established practice based on periods of short-term volatility. 

The short-term vs long-term

Although this market turbulence can understandably be concerning, it’s nothing we haven’t seen before. Using the S&P 500 as an example, there have been 13 instances of bear markets since 1942 (as of the end of June 2022). Compared to bull markets, bears are outnumbered and outlasted – the average bear market lasts just 11.3 months, while the average bull lasts 4.4 years (1). This suggests that there’s an upward bias in markets, which is also evident in graph 2, which displays the 10-year returns of global indices in pound sterling.

Source: Bloomberg, data from 01/07/2012 – 30/06/2022

Looking at these returns, you can understand why we highlight the importance of adopting a long-term approach to investing, as it allows you to look through short-term turbulence. That said, past performance isn’t a reliable indicator of your future returns.

FAANGs losing their bite

Despite the headline of the S&P 500 becoming a bear market in June, the reality is that many stocks have been in this environment for several months. Growth stocks, which are companies that are expected to produce higher-than-average long-term earnings, have endured a particularly challenging year, as they are sensitive to interest rate increases.

FAANGs, which are arguably the most prominent growth stocks, have not been immune to this fall in performance. Despite their popularity, various economic and company-specific reasons have led to sizeable declines across the FAANGs this year, as displayed by their year-to-date returns below in pound sterling.

Source: Bloomberg data from 01/01/2022 – 30/06/2022

These returns demonstrate one of the potential benefits of diversification. Given their strong performance over recent years, some investors may have been tempted to build an investment portfolio that only contained FAANG stocks. However, as the table above illustrates, this portfolio would have been extremely vulnerable in the current market conditions. A well-diversified portfolio allows investors to participate in the upside of growth stocks, such as the FAANGs, but can also dampen volatility during turbulent periods.

The benefits of diversification

Diversification is often described using the old cliché of ‘don’t put your eggs in one basket’. Whilst simplistic, this metaphor captures the premise of diversification effectively – managing a portfolio’s risk through varying its exposure to a range of factors. It’s important to note that diversification does not eliminate a portfolio’s risk, as you will still need to take some risk to generate returns.

As an investment team, we use several methods to diversify your Plans effectively, which include:

• Asset Classes – financial assets, such as bonds and shares, have historically shown low levels of correlation. Spreading investments across these asset classes, therefore, enables us to limit the impact of undesired movements in one asset.
• Geographically – as regions are often in different stages of their respective economic cycles, investing across global markets allows us to mitigate the impact of any country that underperforms. The benefit of geographical diversification is illustrated in graph 1, as the FTSE 100 has fared significantly better than other markets this year.
• Time – possibly the most important form of diversification. The greater the length of the period you are invested for, the higher expected returns and minimal impact from short-term volatility you could experience. Historical data tells us that there is a 97.30% likelihood of generating a positive return from a 10-year investment in the S&P 500 (1).
• Funds – our Plans invest in funds, which are baskets of investments, commonly of different shares or bonds from the same country or stock market. Exposure to a variety of companies, for example, ensures that a fund is not overly sensitive to the performance of a certain stock.
• Fund Managers - this form of diversification is key for our Ethical Plans, which predominantly consist of active funds. Employing a wide range of fund managers allows us to benefit from their diverse views and local knowledge of various markets and companies.

Despite its advantages, the relevance of diversification in current markets – specifically the combination of equities and bonds - has been questioned recently. The unprecedented events caused by the Covid-19 pandemic and subsequent easing of monetary policies by central banks worldwide resulted in a bubble across many assets, including bonds and shares. These abnormal conditions weakened the diversification provided by these assets against rising interest rates. This meant that as inflation concerns escalated this year, and interest rate hikes followed, we saw a considerable decrease in the value of both bonds and shares. However, it can be argued that, as bond prices have dropped and their yields have increased to more normalised levels, the potential benefits of diversification have been restored and are likely to play an important role in these uncertain times.

In summary

The decline in the prices of the hugely popular FAANGs stocks, divergence in the performance of global markets year-to-date, as well as the recent volatility we’ve experienced are timely reminders of the significance of portfolio diversification. Despite the continued uncertainty provided by the Russian invasion of Ukraine, inflationary and recession concerns, and other economic factors, diversification and patience remain crucial in this challenging environment.

 1. https://static.fmgsuite.com/media/documents/052a8c45-d0de-4d16-9962-b66af776928c.pdf

Please remember that past performance is not a reliable indicator of your future results.

With investing your capital is at risk, so the value of your investments can go down as well as up, which means you could get back less than you initially invested.

Wealthify does not offer advice, if you’re not sure whether investing is right for you, then please speak to a financial adviser.