Q4 2024 Commentary: Diversification & the Concept of “Beating the Market”

Pine Haven Investment Counsel, Inc. – Commentary – 4th Quarter 2024

Casey Fitchett & Paige Johnson Roth, CFA®

As we enter the new year, it’s a good time to revisit some of the fundamental principles that guide our investment philosophy, particularly the concept of diversification and why we do not aim to “beat the market”, namely the S&P 500 Index.

The Importance of Diversification - At the heart of our investment approach is diversification—a strategy that seeks to reduce risk by spreading investments across different asset classes, sectors, and geographical regions. This strategy helps mitigate the impact of any single investment’s poor performance on your overall portfolio. By holding a variety of assets, such as stocks, bonds, cash, and real estate, the potential volatility of your portfolio may be reduced, as different asset classes can perform differently under varying market conditions.

Diversification is not about eliminating risk entirely; it’s about managing it. Markets are unpredictable, and no one can accurately predict the next market movement with certainty. However, diversification allows us to avoid the risk of a concentrated portfolio where poor performance in a single stock or sector could significantly affect the entire portfolio.

Why We Don’t Aim to Beat the S&P 500 - The S&P 500 Index is often viewed as the benchmark for the U.S. equity market, and many investors aspire to “beat” it, thinking that it’s a simple goal to strive for. While it is true that the S&P 500 has been a strong performer over the long run, it is essential to understand why we do not set it as our target.

First, let’s acknowledge the reality that the S&P 500 is an index of 500 of the largest and most successful companies in the U.S. It is inherently weighted towards large-cap stocks, particularly those in the technology, healthcare, and financial sectors. As a result, it has benefited disproportionately from a handful of massive winners over the years, like Apple, Microsoft, and Tesla. The index’s performance is often influenced by the success of these few large players, and that may not align with the broader goals of a well-rounded portfolio.

Volatility - Volatility refers to the degree of variation in the price or value of an asset, such as a stock, bond, or other investment, over time. It is a measure of how much the price of an asset fluctuates — the greater the fluctuations, the higher the volatility. Volatility is often used to gauge the risk associated with an investment. High volatility means that the price of an asset can change significantly in a short period, while low volatility indicates that price changes are more stable and predictable.

For example, this volatility has led to max intra-year S&P500 downturns in the past 5 years of -8%,-10%,-25%,-5%, and -34%, respectively.

This image is of a “quilt chart” that shows annual returns for a variety of different asset classes across a 15-year period. The far-left side of the chart shows the annualized return and annualized volatility over the last 15 years for each asset class. Cutting through the middle of the chart is a hypothetical diversified portfolio composed of different weights of these asset classes.1 You’ll notice that while large cap stocks did have the highest annualized return, they also had an annualized volatility of 15.1%. The diversified portfolio came in at only 10.4% volatility over that same time period.

Time Horizon - Your time horizon plays a crucial role in shaping your investment strategy. For those with a longer investment horizon—say, 10, 20, or 30 years—market fluctuations are less of a concern. Over time, the value of a diversified portfolio tends to grow, even with periodic downturns. In contrast, those with shorter-term goals, such as retiring in the next few years, might need a more conservative approach, as volatility could impact the ability to meet specific goals and take necessary withdrawals from the portfolio.

The S&P 500 is a reflection of long-term growth, but its performance can be volatile in the short run. For instance, if your time horizon is shorter than the typical market cycle, the risk of short-term losses could be a major concern. Diversification can help manage the peaks and valleys, potentially leading to more stable returns over time, despite of the market’s short-term swings.

At Pine Haven, our investment philosophy is focused on long-term, sustainable growth rather than short-term performance. The S&P 500, with its heavy concentration in large-cap U.S. stocks, doesn’t fully reflect the global economy or offer exposure to different types of risk and return characteristics. While the S&P 500 may outperform in a given year, there are periods when other asset classes, such as international stocks, small-cap stocks, or bonds, can provide more attractive returns with less volatility.

The Bottom Line - It is human nature to have a short-term memory and feel regret that you have missed out on opportunities. Our objective is not to chase short-term gains or outperform a benchmark like the S&P 500. Instead, we aim to construct portfolios that align with your financial goals, risk tolerance, and time horizon. By focusing on diversification, we seek to build portfolios that offer balanced exposure to different risks and opportunities. While it’s true that we may not always “beat” the S&P 500, we believe our approach will ultimately provide more reliable, sustainable returns over time—while helping you manage the pitfalls of concentrated risk.

1. JPM Guide to the Markets, Slide 59. The “Asset Allocation” portfolio assumes the following weights: 25% in the S&P 500, 10% in the Russell 2000, 15% in the MSCI EAFE, 5% in the MSCI EME, 25% in the Bloomberg U.S. Aggregate, 5% in the Bloomberg 1-3m Treasury, 5% in the Bloomberg Global High Yield Index, 5% in the Bloomberg Commodity Index and 5% in the NAREIT Equity REIT Index. Balanced portfolio assumes annual rebalancing. Annualized (Ann.) return and volatility (Vol.) represents period from 12/31/2009 to 12/31/2024. Please see disclosure page at end for index definitions. All data represents total return for stated period. The “Asset Allocation” portfolio is for illustrative purposes only. Past performance is not indicative of future returns.  

Disclosure: This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third-party sources and is believed to be reliable; however, its accuracy is not guaranteed and should not be relied upon in any way whatsoever. This presentation may not be construed as investment, tax or legal advice and does not give investment recommendations. Any opinion included in this report constitutes our judgment as of the date of this report and is subject to change without notice.

Additional information, including management fees and expenses, is provided on our Form ADV Part 2 available upon request or at the SEC’s Investment Adviser Public Disclosure website, here. Past performance is not a guarantee of future results.