Does Diversification Work?
Diversification – investing in a wide variety of assets to protect your portfolio – is a widely accepted technique for reducing risk. For the past generation, financial professionals have been encouraging their clients to diversify their portfolios away from traditional US-only investments, both stocks and bonds, and to diversify with international holdings or alternative investments such as hedge funds and real estate. In 2014, traditional US investments outperformed both international investments and many key alternative investment types. As a result, some investors were left questioning the benefits of diversification.
Doubting investors may concede diversification reduces overall portfolio risk by spreading the investments around, but if the combined returns for a diversified portfolio are simply going to be less than a traditional US stock and bond portfolio, is it worth anything to diversify a portfolio?
Let’s get a sense of what various asset classes can do. Here are the historical annual returns for nine asset classes which range from the most traditional investments (cash, fixed income, large cap US stocks) to alternative investments (real estate, commodities, hedge funds). We’ve color coded the results by year, with each annual winner in green and the loser in red.
In 2014, we can see traditional US large cap stock and fixed income investments (the S&P 500 and Barclays Aggregate Bond indices) did well while international stocks and commodities lagged.
Testing Diversification: 4 Solutions
Imagine four friends – Joey, Ross, Chandler and Phoebe – each with $10,000 to invest. The date is January 1st, 2004 and each of these friends wants to double their money. If possible, they’ll entertain lower volatility (i.e. low standard deviation of returns), but their overriding goal is high returns. Each of the four friends has a different strategy to maximize their returns.
1 - The Hot Dot Solution
Joey’s investment strategy is based on going with proven winners. He looks at the previous year’s (2003) returns and sees Emerging Markets was the big winner, with a whopping 56% return. Joey is definitely attracted to those returns and puts his $10,000 into Emerging Markets. Look at the table above; notice the 2004 return of 25.55% in Emerging Markets. As a result of his investment, Joey’s $10,000 grows to 12,255 by the end of 2004.
This goes on and on. Joey reinvests his total holdings every year into the previous year’s best performing asset class.
2 - The Contrarian Solution
Ross is a little more sober and thoughtful than his friend Joey. Ross thinks that every dog has his day and reasons that last year’s winner is, in fact, more likely to lose next year. So Ross follows the opposite strategy as Joey. He will continually invest in the previous year’s losing asset class. Ross checks out the returns from 2003 and, noticing that bonds were the weakest performer, places his $10,000 into bonds. Every year, Ross will reinvest his total amount into the previous year’s loser.
3 - The Slow and Steady Solution
Chandler has no idea which asset class is going to outperform in any given year so he diversifies his $10,000 equally between the different asset classes, $1,111 in each. At the end of the 2004, Chandler notes that his real estate investment grew by $351 dollars while his cash allocation only grew by $14 dollars. So, he will rebalance his investments equally at the end of every year.
4 - The Clairvoyant Solution
Phoebe is truly psychic. So, the solution to achieving maximum returns turns out to be very simple for her. If you have several asset types (e.g. large cap stocks, emerging market stocks, real estate, etc.) each with a different rate of return, all she needs to do is invest everything into the single asset class which will have the highest rate of return. Just pick the winner. Easy! Diversification would only hurt Phoebe’s results since she’d be spreading her investments into assets which would, by definition, underperform. Every year, Phoebe reliably reinvests her proceeds into the next winning asset class.
Let’s see where these four friends ended up by the end of 2014.
Phoebe, the clairvoyant, is the big winner with an astronomical rate of return. For lesser mortals, the diversified slow and steady approach has better long tern returns at lower levels of volatility. (Please contact us if you would like the Excel spreadsheet of these calculations.)
We considered other options based on real world behavior. For instance, we considered modeling our four friends as employees in a 401(k) plan, putting in $10,000 every year into different investments, while leaving the previous investments alone. We realized this model, over time, would simply split the difference between the existing diversified and undiversified results as the performance results gradually moved towards more equal weights.
Professional investment analysts already know the diversified approach by simply equal weighting asset classes is only the beginning. A professional would adjust these weights to come up with diversified portfolios with even better historical combinations of risk and return. Generating a combination of investments which mixes these asset types based upon their historical risk, returns, and correlations is a process called optimization, and it is a key element of a prudent investment process.
For now, however, the point is made: diversification may not work in every time period but, historically, it reduces risk and achieves better results. Going back to our example, Joey might have taken a few victory laps around his friends Ross and Chandler in the first investment year (2004), but in the long term, Chandler’s results are more attractive.
On the other hand, if you do know any bona fide investment psychics, go with the Clairvoyant solution. The rest of us have to admit to not knowing which asset classes will outperform in the future, so we will have to be content with a variation on a diversified solution.