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.

Rebalancing away from your winners and into your losers has been found by David Swensen, the chief investment officer at Yale, to add approximately 0.4% to your annual return as compared to a portfolio that has not been consistently rebalanced. Rebalancing also improves your risk-adjusted, after-tax portfolio returns.

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 the Average Wealthfront Diversified Portfolio.

sharpe-ratioComparison-small

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 portfolio Wealthfront recommends to our average investor would have been 0.6 for taxable accounts, and 0.66 for retirement accounts. That means the average rebalanced investment portfolio on Wealthfront could have outperformed 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 article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront clients. Past performance is no guarantee of future results.

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