Diversification feels like a losing strategy in strong up markets, especially if the S&P500 is the winning asset class. Over the last year through April, 30th, the S&P500 is up 30% while the Russell 2000 small cap index is up 19.5%.

Investors question why they should own anything but the S&P500 (US large cap companies), citing recent outperformance. It’s not common for US large cap companies to be the top asset class every year.

The white box (a 60% stock, 40% bond portfolio) in the jellybean chart above will never be at the top, more importantly, it will never be at the bottom in any given year. Scott Galloway would say, “diversification is Kevlar – with it, bad decisions still hurt but aren’t fatal”.

In the chart below I divide the S&P500 by the Russell 2000, which is a proxy to show how expensive US large cap is relative to US small caps. The last time we experienced this kind of a run was the late 90’s.

The data goes back to 2000 and the average value (S&P500 divide by the Russell 2000) for the last 24 years is 2.43. Using that as a line of demarcation, anything above 2.43 assumes US large cap is expensive relative to small caps. Today, it shows large cap stocks are exceedingly expensive. Anything below 2.43 means US small cap is expensive relative to US large caps.

Just because large caps are looking expensive compared to small caps, it doesn’t mean run for the hills. Using valuation metrics like this is historically bad for market timing. But it should be a consideration for long-term investors who are likely overweight large cap companies.

Unless there’s an unforeseen shock to the markets, winning assets don’t suddenly become losers.

Keep in mind smaller companies have also been historically more risky than bigger companies. That extra risk has typically brought higher rewards. As part of a balanced portfolio, that extra risk can help juice portfolio returns over time.

Going back to the same time frame in a total return lens, small caps have had a bumpier ride but have outperformed large caps by 19%.

Long-term investors would want to own names like Google before becoming GOOGLE or Chipotle before becoming CHIPOTLE. Both were part of the Russell 2000 and have since outgrown the index. Owning mid cap indexes and then large cap indexes would capture the growth of a Chipotle through infancy to where it is now. While it’s been wildly fun owning Nvidia stock, the top performers inevitably knocked off their perch.

Admittedly, investors owning 2,000 names, even in an index, would experience more companies that fail, hence the greater volatility. Because of the low odds of success, owning more names should help insulate from back breaking losses.

DISCLOSURES:

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

This document is for your private and confidential use only, and not intended for broad usage or dissemination.

No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of CWA strategies are disclosed in the publicly available Form ADV Part 2A.

Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. You cannot invest directly in an Index.

Past performance shown is not indicative of future results, which could differ substantially.

Consilio Wealth Advisors, LLC (“CWA”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where CWA and its representatives are properly licensed or exempt from licensure.