Long Live Diversification!

I get tired of all of the articles saying that the old standards of buy and hold and diversification are dead. Every time the market takes a dive or things get volatile, I hear the same refrain:

Buy and hold is dead.
Diversification is an easy way to lose.
Diversification is for idiots.

What I want to know is: Where’s the evidence?

I understand that we all hate to see the market drop. And it’s only natural to ask yourself if there was some way to get out before the drop. But no one has a crystal ball.

Now, there is a body of research that supports certain types of market timing (I am not going to go into detail here), but it’s important for average investors to understand:

(1) Successfully timing the market requires a high level of knowledge and expertise, and (let’s be honest) some luck.

(2) The baseline performance of a diversified buy and hold strategy is much better than most investors realize.

In light of all of the criticism, I’d like to focus on the second point for today’s installment of the Portfolioist.com.

So What’s the Baseline?

Before anyone even considers pursuing an active management strategy, they should have a sense of what a well-designed passive strategy can provide. This will provide a “baseline” against which to comparer your expectations.

In late 2010, Burton Malkiel (the author of the investing classic, A Random Walk Down Wall Street) wrote “Buy and Hold is Still a Winner” for the Wall Street Journal, providing a robust defense of diversification and buy and hold strategies. The gist of the article is that a well-diversified portfolio of index funds had, in fact, produced attractive returns over the past ten years—even though the U.S. stock market had lost value over the same period. Dr. Malkiel assembled a portfolio of low-cost Vanguard funds that, collectively, delivered solid returns over the trailing ten-year period (see chart below).

Source: Wall Street Journal

One critique of Malkiel’s analysis, however, is that this out-performing portfolio was designed with the benefit of perfect hindsight (and a number of readers wrote comments to this effect).

Now, it’s pretty easy to stand at the end of 2010 and design a portfolio that has outperformed over the past ten years. The hard part is putting together a portfolio that will outperform for the next ten years. Hindsight is 20/20 and in order to correct this bias, we need to look at the performance of asset allocations after the portfolios were designed and launched.

A Real World Test Case

Target Date strategies, provide an excellent case study for looking at the real-world performance of a well-diversified portfolio (and in highly volatile markets, for the last several years, see “Target Date Strategies Weather the Storm“). We will look at the performance of the largest Target Date Mutual funds over recent years. In addition, we will also look at the performance of Target Date Folios, Target Date solutions introduced by FolioInvesting almost four years ago. The Target Date Folios were explicitly designed to maximize the value of diversification across asset classes. Target Date portfolios (be they mutual funds, ETFs, or Folios) are specifically designed to be a complete buy and hold investing solution and should be highly diversified. So, using Target Date Funds and Target Date Folios as examples of real-world diversified portfolios, what do we conclude about the value of diversification and buy-and-hold?

In the table below, we compare the performance of the Target Date Folios (launched in December 2007) to an index made up of the average of the three largest mutual fund families (which control about 75% of all Target Date assets) and to the S&P 500 Index over this same period. The index is labeled Average of  ‘Big 3’ Target Date Funds.

Source: Folio Investing and Sungard’s FAME database. Performance results do not include brokerage fees.

What the Numbers Tell Us

The Target Date Folios are a blend of exchange-traded funds (ETFs) and include a wide range of asset classes, including stocks, bonds, commodities and Real Estate Investment Trusts (REITs). Investors in the Folios can choose from conservative, moderate and aggressive risk tolerances, however, the Moderate Folio is designed as the baseline for the “average” investor. (Note: the “average” investor represents a series of assumptions about working years, retirement age, ability to save, etc.).

Not surprisingly, the Conservative Folios are the best performing strategies over the past 3.7 years, because less risk has resulted in better aggregate performance. That being said, the simplest predictor of outperformance in recent years is likely to be how much of the portfolio is allocated to bonds and the Conservative Folios do have higher bond allocations. However, this raises another critique of Dr. Malkiel’s analysis: Low-risk asset allocations have tended to outperform in recent years, but being more conservative in volatile markets doesn’t lead to superior long-term asset allocations.

The Value of Diversification is Alive and Well

In order to make a solid argument about the value of diversification and a consistent buy and hold portfolio strategy, we need to look at the performance of investment portfolios since they were launched in December 2007 (a bad period for stocks and almost every high risk asset class) and the performance over the last year (a strong period for equities). If we see that a Fund or Folio out-performs over the 3.7-year period but under-performs during the last year, we can conclude that the longer term out-performance is probably just due to a more conservative asset allocation. If we see that the mutual funds or Folios have out-performed in both good and bad markets, we start to have a compelling case for diversification.

Needless to say, the 3.7 years since the launch of the Target Date Folios has been one of the worst periods for the S&P 500 Index which returned an aggregate -10.9% (including dividends). This period is an excellent test of the value of diversification in managing risk.

The average of the three largest 2010 Target Date mutual funds has returned a cumulative 5.8% over the 3.7-year period, which equates to 1.5% per year. While this performance is not great, it’s not catastrophic in these market conditions. In fact, one could easily say that the 2010 Target Date mutual funds have done their job.

Now let’s turn our attention to the Target Date Folios. The 2010 Moderate Folio has returned an annualized 3.4% over the 3.7 year period, adding about 2.6% per year relative to the average return from the ‘Big 3’ 2010 fund performance.

Over the trailing 12 months, the average of the three 2010 Target Date Folios has returned 12.1%. The 2010 Moderate Folio (the baseline 2010 portfolio design) has returned an average of 3.4% per year over this period and 11.6% over the past 12 months. By maximizing available diversification benefits, the 2010 Conservative Target Date Folios helped to reduce market risk, while maintaining exposure to potential gains from a good year in equities.

Impacts of Diversification in High Risk Portfolios

It’s not surprising that the most conservative strategies (2010 mutual funds and Folios) would have dramatically outperformed the S&P 500 Index because these portfolios have substantial bond allocations. To try to separate the contribution of risk reduction from the diversification component of Target Date Folios and Target Date Funds, let’s look at the longer-term Target Date Funds and Target Date Folios.

The 2040 Moderate Folio, for example, has a trailing 12-month return of 18.2% as compared to 18.5% for the S&P 500. The average of the ‘Big 3’ 2040 Target Date funds over the past year returned 16.5%. The Target Date Funds and Target Date Folios have sufficient exposure to equities to harness a bull run.

When we look at the longer 3.7-year period, in which the S&P 500 returned -3.1% per year, the 2040 Moderate Folio returned an aggregate 1.5% per year versus the “Big 3” 2040 Target Date Fund which returned -2.0% per year.

In the case of the 2040 Moderate Folio, it’s benefitted from the upside of equities in the last twelve months but has also outperformed the S&P 500 by 4.6% per year over its 3.7-year lifetime.

Still Think Diversification is Dead? Not So Much.

For those of you who believe that long-term diversification and buy and hold strategies are “dead” or “…is an easy way to loose…” take a look at your own portfolios over the past 3.7 years and compare the most recent 12 months of its performance to the performance of the Target Date Folios.

If your portfolio has beaten both the 12-month and 3.7 year performance of any of the Target Date Folio risk levels—give yourself a pat on the back. Consider yourself vindicated. You can now make the case that you have the ability to outperform a passive buy and hold strategy.

Let me know how you did it—I really would like to know. Because when I look at the performance of Target Date Folios over the past 3.7 years, I think that the results speak for themselves and vindicate the argument for well-diversified, buy-and-hold portfolios.

Related Links:

Sponsored by Folio Investing The brokerage with a better way.
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3 thoughts on “Long Live Diversification!

  1. Auros Harman

    I’m sure there’s _somebody_ out there whose personal portfolio did better over both 1 and 4 years. Put enough monkeys in front of typewriters, and one of them will write Hamlet, you know?

  2. Pingback: Tax Loss Harvesting Season is Here « Portfolio Investing Blog: Portfolioist

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

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