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Most investors, almost all 401K owners, and the vast majority of professional financial advisors will likely agree that diversifying your investment portfolio across asset classes is the key to long-term success. While history will likely bear out the validity of this thesis, here's a news flash: Diversification is not working worth a darn this year!

That's right, anyone who has been told by their professional advisors that they simply must own stocks, bonds, real estate, commodities, gold, and foreign markets, etc. has actually received pretty bad advice in 2013. (It was also very bad advice in 2008, but that's a horse of a different color.) You see, the stuff that so many investment pros were afraid of coming into 2013 has done quite well this year while the areas that are supposed to smooth out an investor's ride have basically stunk up the joint.

Given that the S&P 500 is up more than 18% on the year, you couldn't be blamed if you thought that most investors are happy with their results thus far in 2013. But in reality, nothing could be farther from the truth as a great many have missed out on the stock market's run and have taken a beating in what is turning out to be a brutal bond market.

How's That Diversified Portfolio Working Out?

If you have owned U.S. stocks in 2013, you likely have a big smile on your face right about now. Despite all the worries about the sequester, Europe, the economy, China, the Fed, and what the boys and girls in D.C. might (or might not) do, the U.S. stock market has enjoyed a stellar year. In fact, at this point in the year, the return for the S&P 500 is roughly double the long-term average. However, the rest of a "well diversified" portfolio is stinking up the joint.

Below is a summary of how the popular ETFs in the major investment classes have performed year-to-date as of Tuesday's close:

  • U.S. Stocks (SPY): +18.58%
  • Foreign Stocks (EFA): +10.30%
  • Emerging Market Stocks (EEM): -6.87%
  • U.S. Gov't Bonds - 7-10 Years (IEF): -7.95%
  • U.S. Gov't Bonds - 20+ Years (TLT): -16.21%
  • High Yield Bonds (JNK): -2.78%
  • REITs (IYR): -1.15%
  • Commodities (DBC): -5.51%
  • Gold (GLD): -18.69%

For years, money managers everywhere have been able to add value and oftentimes outperform the stock market by diversifying across asset classes. If you wanted a steady return, you simply bought bonds, junk bonds, and/or REITs. If you wanted to bump up your results, you added some gold, silver, oil, etc. And if you wanted to outperform the U.S. market, adding some emerging market equity or debt was the ticket. But this year, and likely for many years to come, this strategy isn't working.

To drive this point home even farther, let's look at how a typical diversified portfolio would be performing against the S&P 500's 18 percent gain this year. For example, if you own 50% stocks (30% U.S., 20% Foreign, and 10% Emerging) 30% bonds (10% U.S. 7-10 Treasury's, 10% Junk and 10% U.S. 20+ Treasury's), and 20% "real assets" (10% Commodities, 10% Gold), your overall return on the year is +1.69%. What's interesting about this number is that without the furious rally seen in the emerging markets and Europe over the last two weeks, this number would be negative.

It is also interesting to note that according to Hedge Fund Research, their primary hedge fund index is up less than 4 percent so far in 2013. So, it really doesn't matter how fancy or sophisticated your diversification strategy may be, owning anything other than U.S. stocks has hurt performance this year.

What's Going Wrong?

In short, it's the bond market, the U.S. economy, and the U.S. dollar. The combination of rising rates, an improving economy, and a rally in the greenback has meant falling prices in bonds of all shapes and sizes, commodities, gold, and the emerging markets. And if you believe that the economy is going to continue to improve or that the Fed is going to start backing away from its stimulus programs, you must understand that this situation is going to continue.

The bottom line is that if we are indeed entering a secular bear market in bonds (a strong probability) then the problems being encountered by old-school diversified portfolios are likely to continue - perhaps for quite some time.

To fully understand the situation in the bond market, take a look at a long-term chart of the U.S. 10-year bond yield. First, it is important to note that yields have been trending lower for a very long time. Next, we need to remember that yields have been kept artificially low by the efforts of the Federal Reserve for the past five years. So, with the economy now improving (albeit modestly), one can argue that bond yields have nowhere to go but up from here. And if this is the case, then bonds, bond funds and bond ETFs are going to continue to be a very bad place to be.

Assuming there are no hysterics in the market, tomorrow we will take a look at what we feel is a smarter way to play the diversification game .

Turning to this morning... After President Obama announced that he is shelving plans to punish Syria militarily, global markets breathed a modest sigh of relief. However, celebrations weren't in order due to the fact that the news was already "baked in" to market pricing. As such, overseas markets were mixed and U.S. stock futures are pointing modestly lower in the early going.

Positions in stocks mentioned: none

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