Diversification In Pictures

If a picture is worth a thousand words, when it comes to the payoff of diversification, a chart or two may prove even more valuable.

The principles over at MyPlanIQ, a firm specializing in sorting through corporate 401k plans and offering suitable portfolios from the funds on offer, have put several together. They show what portfolio theory teaches: that adding more asset classes to a portfolio improves its performance over time.

Here is a comparison of the performance of portfolios of increasing diversity from 2009 to the present. (Click chart to enlarge):

In the graphic above, the lowest orange line is a portfolio consisting of three index funds tracking different asset classes : 40% in Fixed Income, 30% in US Stock, 30% in International Stock.

Green is slightly better with four funds: 40% Fixed Income, 20% US Stock, 20% International Stock, 20% REIT.

Gray is better still, with five funds: 40% Fixed Income, 15% US Stock, 15% International Stock, 15% REIT, 15% Emerging Markets Stock.

Blue is tops with six funds: 40% Fixed Income, 12% US Stock, 12% International Stock, 12% REIT, 12% Emerging Markets Stock and 12% Commodities.

As the graph shows, the more assets, the better the returns.

In the short term, as the diversification and returns rise, investors seem to be better compensated for their investment risk. Over one year, the Sharpe Ratio ranges from 83% in the portfolio of 3 asset classes, up to 105% for the portfolio of six. Higher is better.

Over a longer stretch, the risk-adjusted returns of all portfolios comes down. Looking back to 2001, the four-sector portfolio, for example, has an annualized return of 6.62% and a Sharp Ratio of  40.29%.

The very best performance over the ten-year period comes from the five-asset portfolio, with a 7.71% average annual return and a Sharpe Ratio of 44.93%. The six-sector portfolio has a slightly lower 7.61% annualized return but a better 49.7% Sharpe Ratio.

Which seems to imply that diversifying pays, but there may be a diminishing return at some point.

Here is a chart of the same group over the longer time horizon, stretching back to 2001. (Click chart to enlarge.):

2 thoughts on “Diversification In Pictures

  1. Neil Kennedy

    Portfolioist,

    I have been intrigued by MYPLANIQ for sometime now. It seems to me they have a tool that many investment advisers could utilize to their advantage. If you could supply more back ground on them, and their process I would be grateful. It would be interesting to see MYPLAN add their tactical style into these same chart’s and see what may happen.

  2. Simon Napper

    If you want to see the portfolios in comparison, we have a portfolio compare link that allows you to see graphical and tabular results. Here are five portfolios:
    4,5,6 Asset 40% fixed income tactical asset allocation
    5, 6 Asset 40% fixed income strategic asset allocation
    You can adjust the time period as you like.
    http://www.myplaniq.com/LTISystem/jsp/portfolio/ComparePortfolio.action?portfolioString=Four%20Core%20Asset%20Index%20Funds%20REITs%20Tactical%20Asset%20Allocation%20Moderate,Five%20Core%20Asset%20Index%20Funds%20Tactical%20Asset%20Allocation%20Moderate,Six%20Core%20Asset%20Index%20Funds%20Tactical%20Asset%20Allocation%20Moderate,Five%20Core%20Asset%20Index%20Funds%20Strategic%20Asset%20Allocation%20Moderate,Six%20Core%20Asset%20Index%20Funds%20Strategic%20Asset%20Allocation%20Moderate

    For more about MyplanIQ: http://www.myplaniq.com/LTISystem/f401k__about.action

    More on the tactical asset allocation strategy
    http://www.myplaniq.com/LTISystem/jsp/strategy/View.action?ID=1003

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s