Does Diversification Work?
In March of 2015, we challenged a basic tenet of modern portfolio theory: does diversification actually work as an investment strategy? For the past several years, investors might have been better served by avoiding traditional diversification plays and just focus on the past winners. More specifically, US equities have been dominating the investment landscape since the end of the financial crisis in 2009. Would investors be better served by ignoring alternative asset classes, international stocks and bonds, and just concentrating their money into US stocks and bonds instead?
To answer this question, we ran a little test. The test was broad and simplistic, but still revealing. First, we looked at the annual historical returns for nine asset classes, traditional and non-traditional. Next, we evaluated the results of four investment strategies, to determine which worked best in the long term. As a reminder, the four investment strategies were:
- The hot dot.Invest your money into the previous year’s winner.
- The contrarian.Invest your money into the previous year’s loser.
- The diversified.Equally split your money between all the asset types.
- The clairvoyant.Use a crystal ball and simply place your money in next year’s winner.
Obviously, the clairvoyant strategy worked best. For real-world investors without psychic abilities, the diversified approach was the superior strategy.
Adjusting and rerunning the test
It’s been about five years since we’ve run the test, but market watchers have pointed out that the strength shown by US equities have been persistently good during past five years. Given the long term, seemingly unchanging strength of an asset class, might that affect the dominant strategy?
We decided to re-run the test, but we made a few adjustments:
1 – We won’t bother calculating the clairvoyant, psychic investment strategy. We are going to stick with investment strategies in the realm of the possible.
2 – We will include year-to-date 2019 performance. It has not yet been a full year, but with just a few weeks to go, it’s still beneficial to include 2019 performance in this informal test. This is particularly true because it is the strength of this year’s winner which prompts us to revisit this exercise.
3 – Standard traditional asset class indices (e.g. the Russell 2000) remain the same, but we’ve changed some of the less common, alternative indices to those which update more frequently – which is necessary to calculate 2019 data. Specifically, we’ve spliced in index returns of the Bloomberg Commodity and the Morningstar Broad Hedge Fund indices into our data set.
Historical Returns – revisited in 2019
With these caveats noted, let’s reconsider the historical returns for nine asset classes which range from the most traditional investments (large cap US equity, small cap US equity, international developed equity, emerging market equity cash, US aggregate fixed income, cash) to alternative investments (real estate, hedge funds, commodities). We’ve color coded the results by year, with each annual relative winner highlighted in green and the relative loser in red.
Retesting Diversification: 3 Solutions
Imagine three friends – Joey, Ross, and Chandler. Each friend has $10,000 to invest. The date is January 1st, 2004 and each of these friends wants to maximize their investment return. Each of these friends has a different strategy to maximize their returns. They would prefer lower volatility (i.e. low standard deviation of returns), but their overriding goal is maximizing returns.
1 - The Hot Dot Solution
Joey’s investment strategy is based on going with proven winners. He looks at the previous year’s returns and places his $10,00 into that asset class. Every year, Joey will fully reinvest his money into the previous year’s best performing asset class.
2 - The Contrarian Solution
Ross will follow the opposite strategy. Ross invests his $10,000 into the previous year’s losing asset class. Every year, he’ll fully reinvest into the previous year’s worst performer.
3 - The Diversified Solution
Chandler diversifies his $10,000 equally between the nine different asset classes. Each year, Chandler will rebalance his money equally at the end of every year.
Let’s see where these three friends ended up by November 30, 2019.
Joey ended up with $14,382. Some years were very successful. For instance, in 2005, the Emerging Markets asset class had two sustained years of very high returns, which is exactly the sort of circumstance his strategy needed to excel. On the other hand, while Emerging Markets was the highest performing asset class in 2017 (up 37%), that quickly reversed in in 2018 with that asset class at the bottom of the heap.
Ross ended up with $14,012, performing just a little worse than his friend Joey. Ross had some opportune investment selections along the way. For instance, Emerging Market valuations were deeply depressed in the 2008 financial crisis, so he was able to take advantage of the 78% price snapback in 2009. However, the years between 2013 and 2016 were particularly damaging for Ross’s portfolio since Commodities experienced a sustained downward trend, which is exactly the sort of circumstance his portfolio is most damaged by.
Chandler ended up with $26,477, generating more than three times the profits of his friends. Almost every year, Chandler had to experience some hardship and some lucky breaks, but he is clearly the winner of this scenario. Chandler’s approach of equally weighting his investments lacks the sophistication of a rigorous asset optimization study (which might have increased his returns given the level of volatility risk he was willing to adopt), but it did ensure his broad and continuous participation in securities markets, most of which tend advance over time.
2019 and diversification
The past five years of data did change the results slightly. The ongoing, continuous weakness of certain asset classes (i.e. commodities) has reduced the efficacy of the contrarian strategy, which had run ahead of the hot-dot strategy last time we ran the test in 2014. However, the overwhelming relative strength of the diversified approach remained unbeaten in both tests.
We acknowledge the strength of US equities. Thus far, the S&P 500 – the most common stand-in for our stock market – is the clearest outperformer, up over 27%. Moreover, of the nine broad asset classes we selected, the S&P 500 has been one of the better single performing asset classes over the past decade, just behind the alternative real-estate indices. Given this backdrop, we understand the temptation to focus on the most recent winner and the attraction of the hot-dot investment strategy.
On the other hand, more rigorous, professional, long term studies (running much longer than 15 years) continue to suggest an unpredictable cyclicality of strength between many asset classes. In other words, a 10-year cyclical shift between international vs. domestic asset dominance is entirely possible. Trying to divine when, precisely, that cycle will change would require clairvoyance, an attribute not usually attainable.
Diversification may not work in every time period but, historically, it is a valuable tool to reduce risk and achieve better results. Even our limited, unrealistic test still finds value in the diversified approach.