The Benefits of Diversification

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.

11 Responses to “The Benefits of Diversification”

  1. Steve August 1, 2013 at 4:59 pm #

    Nice article. You’ve done a great job illustrating how diversification achieves a higher risk-adjusted return. However, you haven’t explained why you should even care about risk-adjusted returns. If I’m investing for 40 years, what matters is the overall return. Why care about short-term volatility?

    • Andy Rachleff August 5, 2013 at 3:05 pm #

      The reason you should care is there has been a large amount of research, most notably from DALBAR, that has shown individual investors don’t buy until the market has gone up and then sell when it drops. Obviously that is the opposite of what you should do, but human nature is hard to fight. You may say you can ignore short term volatility but the data would prove otherwise.

      If you are assigned a portfolio that has higher risk (volatility) than you are truly comfortable with then you are much more likely to sell when the market drops because it will go down temporarily more than you want. DALBAR has repeatedly found that by buying after market increases and selling after market drops leads the average investor to lose on average 5% per year from what they would have earned if they just left the money invested and rebalanced periodically.

      By putting you in a portfolio that matches your true risk tolerance (behavioral economists have consistently found that individuals overstate their tolerance for risk) we can reduce the likelihood you will pursue the bad behavior DALBAR has discovered. That should result in much higher returns. Trying to max our returns will likely lead to a volatility level that will lead to bad behavior. Thus you need to be conscious of risk adjusted returns.

  2. weybridgegibbo August 2, 2013 at 1:02 am #

    “Rebalancing away from your winners and into your losers …… has been found to add approximately 0.4%” Although a benefit this does not seem to be as high as one would expect, and this questions whether the benefit is worth taking up. Can you advise if the 0.4% is before or after rebalancing costs of selling out of one asset and into another. For the individual investor the costs can be quite high, even on low-cost internet dealing platforms.

    • Andy Rachleff August 5, 2013 at 2:55 pm #

      The benefit from rebalancing is net of all transaction fees on Wealthfront (because there are no transaction fees on Wealthfront). Considering that the benefit from rebalancing is lower than our advisory fee and we do it all for you then why wouldn’t it be worthwhile? A significant amount of research has found individual investors intend to rebalance but seldom actually do it. 0.4% per year compounded over a long period of time can add up a significant amount of money.

  3. rootsCanada August 7, 2013 at 2:46 pm #

    How often, and in what scenarios/situations does Wealthfront rebalance the portfolios of its customers?. Is the rebalancing benefit available for all customers, regardless of how much is invested by the customer?.

    • Andy Rachleff August 7, 2013 at 5:02 pm #

      Wealthfront employs threshold based rebalancing which has consistently been shown by research to be better than time based rebalancing. We explain our approach in detail in our investment methodology white paper. Optimized rebalancing is offered to all our clients independent of account size.

  4. Miguel Octavio August 8, 2013 at 2:39 pm #

    Well, I have a different read on the graph: Why diversify when Emerging Market Bonds have always been in the top five, with excellent returns except for one year, in which they still beat five of the ten asset classes.

    • Andy Rachleff August 12, 2013 at 8:12 am #

      Because the likelihood that it will remain in the top five is low due to reversion to the mean and it isn’t worth it on a risk adjusted basis.

  5. Jeff August 20, 2013 at 8:27 am #

    Thought you guys might find this news article interesting on several fronts:
    * Diversification among some wealthy investors
    * Returns eaten away by fees.
    These are 2 areas you guys are fixing.
    http://www.businessinsider.com/how-super-rich-invest-2013-8

  6. Abe March 20, 2014 at 9:40 pm #

    Do you provide the source for your reference indexes? For example what does it mean when it says “Real Estate”?

    • Andy Rachleff March 21, 2014 at 10:19 am #

      Please go through our questionnaire and you’ll see what ETF we recommend for real estate. We also show the second and third best choices

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