The Power of Effective Diversification

Diversification is one of the most misunderstood concepts in investing.

If you read a good explanation of the strategy, you’ll learn that the goal of diversification is to combine different investments that tend not to be driven by the same factors in the economy. So when one investment lags, the others in the portfolio gain ground (or at least will be unaffected)

For example: Combining gasoline stocks with bicycle manufacturers in your portfolio. When gasoline is cheap, people drive more and bike less. When gasoline prices start to rise, people usually cut back on their driving and start biking to work. Either way, your portfolio is now less exposed to the risk of a downturn in demand for either bicycles or gasoline.

The Case for Low Correlation

Many people mistakenly believe that diversification is simply about holding lots of different investments. Therefore, it’s common to hear people blame the failure of diversification for the substantial losses that their portfolios suffered in high-volatile periods like in 2008–2009. The reality, however, is that people assumed their portfolios were properly diversified when, in fact, they were not.

Real diversification requires that we thoughtfully combine assets in a portfolio, understanding how moves in one asset are likely to offset changes in others. In mathematical terms, real diversification is about combining assets that have relatively low correlation to one another. Interestingly enough, the origins of the mathematical framework for effective diversification have not changed much since its introduction by Harry Markowitz in the 1950s. Markowitz discovered that you can reduce risk with no reduction in return simply by combining stocks or other assets which do not move in tandem with one another.

Today, a well-diversified portfolio looks very different from what most investors are accustomed to seeing.  Simply combining non-U.S. stocks with U.S. stocks has remarkably little diversification benefit.  In some cases, combining international stocks with U.S. stocks will make a portfolio more risky rather than less risky (and this effect was clearly observable well before the most recent market crash in 2008 and the subsequent Eurozone crises).

Target Date Folios: Designed for True Diversification

Target Date Folios, developed by Folio Investing, are a case study in effective diversification.  Launched in late 2007—just before the market crash of 2008—these portfolios have performed to expectations (to view their latest performance, visit Folio Investing).

After seeing their track record, many people assumed that the Target Date Folios were simply less risky (e.g. held more bonds) than many of their counterparts, thereby outperforming  many other Target Date funds in down markets, but would ultimately underperform when the market rallied.

The past three years provide an outstanding illustration that this is not the case. Let’s take a look: Over the past three years, the stock market has enjoyed an incredible rally. The S&P 500 (including reinvested dividends) is up by more than 40% from the end of August 2009 through the beginning of August 2012, (albeit, with substantial volatility along the way). However, it is in this type of volatility that we see how true diversification reacts versus a standard low-risk portfolio that outperforms in down markets and underperforms in market rallies.

Diversification in Real Life

The chart below shows the funded performance of the Target 2020 Moderate Folio versus the S&P 500 from the end of August 30, 2009 through August 1, 2012. The Target Date 2020 Moderate Folio has not only kept up with the broad market’s rally with a 39% total return (vs. 42% for an investment in the S&P 500), but here we can clearly see the hallmarks of true diversification which are:

  1.  The 2020 Moderate Folio had far less volatility than the S&P 500.
  2. The 2020 Moderate Folio also rode out the huge market drop in August of 2011 with less in losses than the S&P 500.

This example is a textbook illustration of how diversification is supposed to work.

In text books that show examples of how diversification works in theory, the authors have the benefits of hindsight. It is easy to find cases in which you could historically have held assets with offsetting risks.  The problem with such examples is that they are simply hypothetical.  The results generated by Target Date Folios (as shown above) are real-world returns generated with real money.

Are Bonds the Silver Bullet?

Could the impressive outperformance generated by the Target Date Folios simply be attributed to bonds’ rally in recent years?

In a word: No.

The chart below shows the same three-year period for the 2020 Moderate Folio versus the iShares Barclays Aggregate Bond fund (AGG) which is a standard benchmark for bonds. Bonds have underperformed the stock market as a whole over this same time period. Therefore, simply holding a large allocation to bonds is not sufficient to provide for the level of performance generated by a well-diversified portfolio.

Lessons Learned?

Diversification has performed just as theory suggests it should.

To build an effectively diversified portfolio, you need to hold assets that work well together to mitigate risk, while maintaining exposure to returns from stocks and other risky/high-return asset classes such as REITs.  Real diversification is far more than simply having a portfolio which holds a large number of securities. In Part II of this article (which we will publish next week), we will explore what a diversified portfolio looks like in today’s market.

Related Links:

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

7 thoughts on “The Power of Effective Diversification

  1. Jon

    Good article. i wrote a book about my strategies that are designed around this same philosophy or common sense approach. They are now available to investors at Folio. Thank you.

  2. Stephen Harlin, MD

    Geoff, nice reminder piece and key points.

    Very briefly, in a two asset portfolio (equities/bonds), allocated using a minimum variance algo – is the tradition of using IEF/TLT to achieve a low correlation, on the bond side, still the right and only approach? Would any liquid, low vol, and negatively correlated instrument serve just as well? Grateful.

  3. Pingback: Tax Loss Harvesting: Share Your Pain with Uncle Sam « Portfolio Investing Blog: Portfolioist

  4. Geoff Considine Post author

    Stephen: If you can find a liquid asset class with as low a correlation to equities as government bonds, this could be fine–with caveats. First, this would need to be an asset class for which you have high confidence in the stability of the correlations and that the equity risk premium will be present. For a long time, financial academics questioned whether commodity indexes based on rolling futures contracts would have a positive equity risk premium. There is no guarantee, of course. Liquidity is a key consideration, as you note. As many of the large endowments have discovered, illiquid assets can be an enormous drag on performance if you need to unwind a position.

  5. Pingback: The Power of Effective Diversification: Part II « Portfolio Investing Blog: Portfolioist

  6. Joyce

    Why did you choose August of 2009 and not March? The market bottomed in March and I’ll wager the results look very different if you start the comparison in March!!

  7. Geoff Considine Post author

    Hi Joyce:

    The Target Date Folios were funded with real money in August 2009–this determined the choice of period, as well as that this is right on 3 years. Folio has also tracked them as model portfolios since late 2007. The model portfolio performance and funded performance mathc very closely, but the decision to track the Folios using funded performance was to eliminate any concerns around that issue.

    There is no doubt that if you started tracking a diversified portfolio at the absolute bottom of the S&P500, things would look different–but that is entirely an arbitrary choice. The same could be said of gold or oil. If you started a comparison of any diversified portfolio vs. the global minimum of gold prices previous to the current rally in gold, gold would out-perform almost anything. It would be unclear what that would tell us, however.

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