The Benefits of Diversification

August 1, 2013 |

We’ve been gratified by the feedback we’ve received on our recent post Why You Shouldn’t Just Invest In The S&P 500. However some of our readers are still grappling with the question of why a broadly diversified portfolio is better than a portfolio that includes only one asset class. This follow-up post includes more data and ways to visualize the value of diversification.

The interactive graphic below ranks the returns of 11 broad asset classes for each of the past 10 years (Click on an individual asset class in the legend to see where it ranks each year). The winner in one year – the asset class that outperformed all the others – was never the winner the following year. This helps illustrate the danger of investing in only one asset class, and why it’s important not to chase performance by adding to your winners from the prior period. Doing so exposes your portfolio to unnecessary risk and, over time, can reduce your returns.

The chart, based on a format first developed by Jay Kloepfer, of investment consulting firm Callan Associates, illustrates a phenomenon called regression to the mean — if a variable is extreme on its first measurement, it will tend to be closer to the average on its second measurement. The average return for US Stocks over this period was 9.5%, so after a year in which it outperformed, we’d expect it to move closer to that average.

The chart also shows the range of returns of all the asset classes. Some are incredibly volatile. For instance, Emerging Markets stocks returns ranged from -54.5% in 2008 to 74.5% in 2009. Municipal Bonds, in contrast, had only one very slightly negative return over the 10 year period, but also never had one that exceeded 10.2%.

Volatility, as measured by the standard deviation of returns, must be taken into consideration when you compare the returns of different investments, asset classes or portfolios.

You can see from the chart why you shouldn’t benchmark the performance of a diversified portfolio against a single asset class. It is an apples-to-oranges comparison, because a diversified portfolio will have less volatility over extended periods of time.

Diversification enables rebalancing

The natural human tendency is to add to your winners. If you add money to your winning asset classes, you will likely buy at the top of the market. For instance, if you had added money to Real Estate after its stellar year in 2006, you would have been knocked with a loss of more than 17% the following year.   The money you invested in real estate would have been better spent investing in asset classes that performed poorly in 2006 and then did well in 2007.

Compare investments on a risk-adjusted basis

When judged on a risk-adjusted basis, single asset classes generally cannot match the performance of a well-diversified portfolio.

The method most commonly used to compare investments on a risk-adjusted basis is to calculate each investment’s Sharpe Ratio. The ratio was named after the Nobel prize winning economist Bill Sharpe.

In the following chart, we compare the Sharpe Ratio over the last 10 years for the S&P 500 versus a classic diversified portfolio over the same time period. To represent the diversified portfolio, we created a hypothetical portfolio with an asset allocation one would find in a risk level 7 portfolio employed by Wealthfront (risk level 7 is the average risk level for all Wealthfront clients).

As you can see, the Sharpe Ratio for the S&P 500 over the past 10 years was 0.43. The pre-tax Sharpe Ratio for the hypothetical diversified portfolio would have been 0.6 for taxable accounts, and 0.66 for retirement accounts. That means the average rebalanced investment portfolio for this hypothetical diversified account could have outper

formed the S&P 500 by 40-54% on a risk adjusted return basis.

Diversification corrects for human bias

The value of diversification is one of the most difficult lessons of investing, because it is not intuitive. We want to believe we can look at the past and use it to predict the future. In investing, you can’t make those predictions — just as you shouldn’t drive by looking in the rear view mirror. And many of us, depending on our tolerance for risk, are tempted to add to our winners. Greedy, we want the bigger payoff that comes from doubling down on the car we think will win. That’s fun at the racetrack. It’s a bad idea with your investment portfolio.

A diversified and properly rebalanced portfolio guards against both of these human tendencies. Over time, the result is a higher risk-adjusted return.

Disclosure
Nothing in this blog should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront Inc. clients pursuant to a written agreement, which investors are urged to read carefully, that is available at www.wealthfront.com. All securities involve risk and may result in some loss. For more information please visit www.wealthfront.com or see our Full Disclosure. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront does not guarantee the accuracy of the information.


Hypothetical performance is not an indicator of future actual results. Hypothetical results are calculated by the retroactive application of a model constructed on the basis of historical data and based on assumptions integral to the model which may or may not be testable and are subject to losses.


Wealthfront assumed we would have been able to purchase the securities recommended by the model and the markets were sufficiently liquid to permit all trading. Hypothetical performance is developed with the benefit of hindsight and has inherent limitations. Specifically, hypothetical results do not reflect actual trading or the effect of material economic and market factors on the decision-making process. Actual performance may differ significantly from hypothetical performance. There is a potential for loss as well as gain that is not reflected in the hypothetical information portrayed. Investors evaluating this information should carefully consider the processes, data, and assumptions used by Wealthfront in creating its historical simulations.


Hypothetical results are adjusted to reflect the reinvestment of dividends and other income and, except where otherwise indicated, are presented net of fees.


The S&P 500® (“Index”) is an index of 500 stocks seen as a leading indicator of U.S. equities and a reflection of the performance of the large cap universe, made up of companies selected by economists. The S&P 500 is a market value weighted index and one of the common benchmarks for the U.S. stock market.


The S&P 500 (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Wealthfront. Copyright © 2015 by S&P Dow Jones Indices LLC, a subsidiary of the McGraw-Hill Companies, Inc., and/or its affiliates. All rights reserved. Redistribution, reproduction and/or photocopying in whole or in part are prohibited Index Data Services Attachment without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.

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