A Properly Diversified Portfolio Will Help You Capture Most of the Market’s Gains While Reducing Volatility
Diversification is the single greatest factor in determining long-term investment returns. Don’t put all of your eggs in one basket. You’ve probably heard that phrase before, and for good reason. When investing, the less diversified you are, the more risk you’re generally taking. Investing in a single stock can provide tremendous returns, but it can also wipe out most of, or your entire investment. Even if you don’t invest in a single company, the same can be said about investing in just one asset class or sector of the market. While the chances of your investment dropping to zero is greatly reduced, you’ll be sure to experience a good deal of volatility. Some years will be great, while others will leave you in the dust as other types of investments perform better.
This is where diversification comes in. As you spread your money out across different stocks and different asset classes, you’re in a better position for weathering the inevitable volatility of the markets. Some of your holdings will be up, and others will be down. But instead of betting on one or two and hoping for the best, you can take a hands-off approach that will allow you to realize most of the market’s gains while minimizing the impact of losses.
The Periodic Table of Investment Returns
Below, I want to introduce to you one of the best ways to illustrate the importance of diversification. It is called a period table of investment returns. To begin, I want to show the table in its entirety. I’ve included some of the most popular asset classes, and you can click on the image to see a full-size version. This table covers the past 20 years.
So, what can we gather from this at first glance? It becomes fairly obvious that there are no easily recognizable trends. Some of the colors are all across the board. Just look at the Russell 2000 Value block. On more than a few occasions, it would go from one of the best performing one year to nearly the worst the following year, and vice versa. And at only 3 times over the past 20 years did one asset class remain the top performer for two years in a row. You can already begin to see that by investing in a narrow band of companies or an asset type, you’re probably going to experience a good deal of volatility. But, let’s examine this chart in a little more detail.
Value vs. Growth Stocks
Both the growth and value monikers come from the fundamental analysis of companies. Value stocks are companies that are relatively cheap when compared to its peers, have a low P/E ratio, and tend to offer dividends. Value stocks tend to be mature companies that are not as focused on rapid growth of the company. On the other hand, growth stocks tend to be just the opposite. They may be priced relatively higher with higher P/E ratios and are generally younger and focused on growing the company. This means it is not likely the company will issue dividends, and instead reinvest in the company to spur additional growth. Two different types of companies, so let’s see how they did over the past 20 years:
You may find this shocking, as there are quite a few instances where in the same year, there can be a significant disparity between these two types of stocks. They are, after all, both stocks. People tend to think that investing in stocks is investing in stocks, but as you can see, depending on what type of stocks you invested in, you could have wildly varying results. In some cases, one may have outperformed the other by 20% or more in the same year, and in some years, one saw a significant positive return, while the other saw a substantial loss. Again, this clearly illustrates why it may not be a good idea to put all of your eggs into one basket.
Average Annual Returns:
- Growth: 8.81%
- Value: 13.30%
Best / Worst Returns:
- Growth: 51.19% / -30.26%
- Value: 46.03% / -21.77%
A Look at a Diversified Equity Portfolio
For the sake of comparison, let’s take a look at what a diversified 100% equity portfolio looks like. For this illustration, the portfolio consists of:
- 35% Russell 1000 Growth Index
- 35% Russell 1000 Value Index
- 15% Russell 2500 Index
- 15% MSCI EAFE Index
The first thing you’ll probably notice is the lack of extremes. A diversified equity portfolio, while never the top performer, was also never at the bottom either. This portfolio held in a narrower range just above the midpoint. So, by investing in value, growth, and some foreign stocks, you take out the extremes and have a portfolio that isn’t nearly as volatile as holding just one or two asset classes.
Average Annual Return: 11.59%
Best / Worst Return: 32.88% / -20.25%
A Look at a Balanced Portfolio
So far we’ve taken a look at a few individual asset classes and a 100% stock portfolio, so what happens when you add some bonds into the mix? For this portfolio, we’re going to look at holdings of 45% stocks and 55% bonds. The portfolio holdings include:
- 15% Russell 1000 Growth
- 15% Russell 1000 Value
- 7.5% Russell 2500
- 7.5% MSCI EAFE
- 55% Merrill Lynch U.S. Broad Market Bond
As expected, the balanced portfolio also has a pretty narrow range, and for an almost 50/50 mix, it falls right about in the middle. Clearly, adding bonds can significantly reduce volatility, and for those of you who hate to see big losses, this can really help you sleep at night. But, even though it isn’t as volatile, how do the returns fare?
Average Annual Return: 9.65%
Best / Worst Returns: 27.74% / -3.35%
This is where a balanced portfolio really shines. The difference between the best and worst years is 31.09 percentage points, whereas the diversified equity portfolio comes in at 53.13 points. With over a 20 point lower differential, the average annual return was only 1.94% lower, and even with 55% bonds, the portfolio saw nearly a 10% average return. Obviously, having a greater allocation in stocks will yield higher average returns, but when it comes to being able to stomach losses, the balanced portfolio, with a worst year of only about a 3% loss is comforting to the average investor.
What Does This All Mean?
You’ve often heard that past performance can’t predict future results, and this table clearly shows this. If you’re jumping into a hot investment because it was a top performer for the past six months or year, the chances of it continuing to do so is a coin toss. Look at the commodity block on the chart. In 2005 it was the best performer at over 25%. If you saw these returns and listened to the media about how hot commodities were and got in, look what happened in 2006. Dead last in performance, and lost over 15%. And as quickly as it dropped, it rose to the top yet again in 2007. If you were basing your investment decision on the previous year’s performance, you would have always bought high and sold low, which is no way to make money.
There also aren’t many surprises on this periodic table. Over the past 20 years, which has seen a number of ups and downs, the average returns are pretty much what you’d expect. Equities hang on to the upper half of the chart with average returns from around 9-13%. Bonds are at the bottom with roughly 6-8% annual returns. You can project back even further, and the overall average returns will not differ much.
So, if you invest in stocks over the long run, you’re bound to do pretty well. But what you have to decide is how much volatility you are willing to stomach. If you don’t mind 20% returns one year and the possibility of 20% losses the next, then you can be comfortable in an aggressive 100% stock portfolio. If you like the high return of stocks, yet aren’t comfortable with such drastic performance swings, then a more balanced portfolio may help you stay the course. You’ll still see the bulk of the upside, but significantly minimize the downside, and reduce your volatility a great deal. A good 401k plan should have enough investment options to allow you to create a diversified portfolio that works for you, or many of the target date funds accomplish the same thing.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
What software is this from, it looks very fresh. I'm trying to diversify with software (mathematical assistance) using Sharp ratios. Any suggestions?
Great post. I think this supports the argument, which has been supported by Buffett, to buy everything through low-cost, highly diversified index funds. If you execute and stick with this plan, you'll beat most your neighbors and professional investors.
The challenge is having the behavioral discipline to stick with it through thick & thin.
john: Buffet actually is a big fan of indexing for individual investors, since over a decade ago: 'Warren Buffet stated in a February 1996 investment letter to his Berkshire Hathaway shareholders: “…the best way to own common stocks is through index funds"'.
Interesting to hear that Buffet is not a fan of diversification. Personally in times like these, I like to diversify but also build up dividends.
John - What do you think those reports and earnings statements are going to tell you that the market hasn't already figured out? Unless you possess a crystal ball that accurately predicts the future at least 75% of the time, there is no way you're "probably" going to beat the market. But good luck with that.
Good stuff! One of the problems is figuring out what the 'long term' is - there have been long periods of time in the past where bonds have out-performed stocks.
John - Buffet is the Wayne Gretzky of investing with a far bigger ego. Just because he can pick stocks doesn't mean everyone (or anyone else) can. :)
John, like you said, if you're someone who has the time and resources to allocate to doing more research, then more power to you. But considering probably 90% or more of the population has no interest in doing this, or has little more than a few dozen funds they are investing with in their retirement plan, that's who I'm really addressing with this.
And JLP, that was more or less a limitation of the software I was using, and I wanted to show the differences between growth and value of the same market capitalization, and the 2000 was what was provided. I figured the S&P 500 index, which is included in the mix, but not analyzed specifically will give people a good indication of the overall large-cap world since that is the most closely followed broad index.
Question: why wouldn't you just use the Russell 1000 Index instead of using both the Growth and Value index?
But what do you say to buffet who says that diversification just means you do not know what you are doing? I agree in general that diversification is good for a person who has no time, but if you can read reports, and company earnings statements you probably can beat the market.
This was part of a financial advisor software package. I don't think anything like this is available to the public. The most powerful suite of tools I'm aware of for the end-user are those that come with the Morningstar premium subscription.
After some hefty Googling I found a site with a series of summaries and weblinks to Portfolio Management software you may be interested in. http://goo.gl/CuXJh