Why Warren Buffett Was Right: “Diversification is Protection Against Ignorance”

The volatility in the broad stock market has shaken investors’ belief in the true value of portfolio diversification. The problem is that many of the people who believe that diversification no longer works, may not know how to build a truly diversified portfolio.

Warren Buffett is widely quoted as saying : “Diversification is protection against ignorance.” I’ll admit, that sounds pretty negative. But what I believe he meant, however, is that you diversify when you are not sufficiently confident to bet on which asset (or asset class) will do well and which will do poorly. 

Clearly, Mr. Buffett has done very well in managing a concentrated portfolio. But are you willing to take that bet?

Target Date Folios: How Diversified Are You?

One of the primary motivators for the design of Target Date funds was to provide investors with access to pre-built, highly diversified asset allocations to help their retirement weather any potential stock market storms. One would argue, if the effectiveness of diversification is in question, then so too is the premise of Target Date Fund strategies. This isn’t necessarily true—it just depends on how diversified your Target Date Fund really is.

Back in 2007, I worked with Folio Investing to design their line-up of Target Date Folios as an alternative to traditional Target Date strategies. Our research found that many Target Date Funds just aren’t as diversified as they need to be—which meant that investors could unwittingly be taking on too much risk for the return they expect.

Like traditional Target Date Funds, Target Date Folios were created with a series of expected retirement dates, varying in five-year increments (from 2010 to 2045). Unlike many traditional Target Date Funds, Target Date Folios use a mix of Exchange-Traded Funds (ETFs) that represent a wide range of asset classes, including stocks, bonds, commodities and Real Estate Investment Trusts (REITS) and also provide three different risk levels for investors to choose from: Conservative, Moderate and Aggressive.  The Target Date Folios (noted below in blue) are diversified across a number of asset classes, with the specific number of assets and weights calculated to maximize the expected return at each risk level.

To date, Target Date Folios have more than 3.5 years of performance data that can be used to examine how the theory has held up in practice. 

Watching Diversification Pay Off

In looking at the performance, it occurred to me that the trailing three-year returns provide an interesting way to show the effectiveness of diversification.  The table below shows the annualized three-year return (through July 25th) for the 24 Target Date Folios along with a number of iShares ETFs that represent core asset classes like government bonds and Real Estate Investment Trusts (REITS). The bar chart is sorted from lowest performance (on the left) to highest (on the right). 

Annualized 3-Year Returns (through July 25, 2011)-Folios in Blue and ETFs in Orange

(The annualized returns for the Target Date Folios, from targetdatefolios.com, include the expense ratios of the underlying ETFs. The annualized returns of the individual ETFs are from Morningstar.com.)

What I found interesting is that the two two bond ETFs captured both the best-performing and worst-performing spots in the table. iShares Barclays 1-3 Year Treasury Bond (SHY) returned an average of 2.65% over the past three years, while the iShares Aggregate Bond Index (AGG) returned an average of 6.65% per year.

On the opposite side of the spectrum, the iShares MSCI Emerging Markets Index ETF (EEM) was the second-best performing individual asset class, with an annualized return of 5.64%. While the SPDR S&P 500 ETF (SPY) has risen considerably in the last year or so, it has annualized return of only 4.25% for the past three years.

What if You Had a Perfect Forecast?

So let’s say you had the remarkable ability to predict that either an aggregate bond index or an emerging market stock index was going to outperform the broad market three years ago. All you needed to do is buy one (or both) of these ETFs. But what if you’re not as confident in your predictions, and decided to “play it safe” by choosing to invest in a Target Date Folio?

Let’s use the 2030 Moderate Folio as an example which has a trailing three-year annualized return of 5.06%. Yes, the Emerging Market ETF has returned 5.64% per year over the same period. And yes, an investor with a perfect forecast into the future would have made 0.58% more by investing in the Emerging Market ETF.

Holdings of the 2030 Moderate Folio

An investor who had less than perfect confidence in any forecast might have invested in the 2030 Moderate Folio and would have spread her bets across twelve different sectors and asset classes, including exposure to multiple classes of bonds, Emerging Markets —and given up only 0.58% per year:

The choice of a diversified portfolio vs. a concentrated portfolio is a reflection of our desire to bet on which sector will out-perform. In the best case, it has been worth around half a percent over the last three years. 

The 2010 Conservative Folio: A No “Regrets” Approach?

Now, let’s imagine that three years ago you predicted that stocks were likely to fall and that bonds were a better choice. You could either choose between the Aggregate Bond Index (AGG) or the most conservative of all of the Target Date Folios—the 2010 Conservative Folio—which has 73% allocated to bonds and 27% allocated to other asset classes.

Once again, if you firmly believe that your stock market prediction is infallible, you simply buy AGG. Over the three last three years, AGG has returned an annualized 6.65% while the 2010 Conservative Folio has returned 5.86%. However, an investor who chose to invest in the 2010 Conservative Folio would have spread their bets across nine different sectors and asset classes. 

Now, don’t get me wrong—a perfect prediction worth 0.79% per year is nothing to sneeze at. For investors not ready to predict the market—the 2010 Conservative Folio offers a good “no regrets” solution. 

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The views expressed in this article are solely the views of the author and FOLIOfn Investments, Inc. neither approves of nor endorses the those views. FOLIOfn Investments, Inc. does not provide investment advice or investment recommendations. It is the responsibility of the investor to determine whether investing in the Target Date Folios or any other securities is suitability and appropriate for them.

3 thoughts on “Why Warren Buffett Was Right: “Diversification is Protection Against Ignorance”

  1. Pingback: When Market Volatility Returns with a Vengeance « Portfolio Investing Blog: Portfolioist

  2. Pingback: It’s Time to Revisit Our Financial Resolutions « Portfolio Investing Blog: Portfolioist

  3. Pingback: The Hidden Risk in Target Date Funds « Portfolio Investing Blog: Portfolioist

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