Carl Richards

Diversification remains one of the most fundamental investing principles, and it’s often one of the most misunderstood. In order to understand diversification you first have to take a comprehensive view of the process of planning a portfolio.

Investors tend to view individual investments in isolation. This often happens because of the focus we place on finding the best overall investment versus figuring out how individual investments work together for the benefit of the whole.

Instead of looking at investments in isolation, we should consider them part of a much larger tapestry, and make sure that the overall picture reflects intelligent portfolio design concepts backed up by an academic approach.

Diversification’s primary power is that it lets us reduce risks that are avoidable.

These avoidable risks include:

• Betting on a particular industry or sector. We see this in the form of trying to pick the next hot sector, like technology, banking or oil stocks.
• Market timing. Most of us believe that you can’t figure out when stocks will zig and bonds will zag. At the same time, we’re often quick to latch on to anything that might look like detailed research about the direction of the markets. In reality, it’s nothing more than a guess.
• Owning individual stocks. While it’s certainly not impossible to identify the next Apple, history proves that it’s highly improbable. Placing large, concentrated bets on individual stocks can be a path to incredible wealth, but so can a single spin of the roulette wheel (if you get lucky).

The magic of diversification is that you can take two individual investments, which when viewed in isolation are individually risky, and blend them in a portfolio. Doing so creates an investment that’s actually less risky than the individual components and often comes with a greater return. In finance, this is as close as we get to a free lunch.

What Diversification Looks Like

Here’s what a sample, diversified portfolio might look like.

First, let’s start with two, undiversified portfolios. Portfolio A is invested 100 percent in United States stocks, as measured by the SP 500-stock index, and Portfolio B is invested 100 percent in international stocks, as measured by the MSCI EAFE index. We’ll use 34 years (1976-2010) for our sample period since it’s the longest period available for which we have data from MSCI EAFE.

During those 34 years the SP 500 had an annualized return of 11.17 percent, and international stocks had an annualized return of 10.72 percent. (All of the portfolios mentioned in this post were rebalanced quarterly. And yes, I know that you can’t invest in an index per se, but you can buy index funds and similar vehicles for next to nothing.)

Now let’s look at the risk associated with each of these hypothetical investments.

Although there are many ways to view risk, for our purposes we’ll focus on the number of negative quarters and volatility as measured by standard deviation (the lower this number is, the better). From 1976-2010, the SP 500 had 42 negative quarters and a standard deviation of 15.39 percent. International stocks had 45 negative quarters with a standard deviation of 17.26 percent.

As you can see, each of these portfolios look risky individually. But the magic of diversification is that when we blend them, the whole is better than the sum of its parts.

So let’s create Portfolio C using use a fairly standard 60 percent allocation to the SP 500 and 40 percent allocation to international stocks. Now this portfolio gets a return of 11.21 percent. While that’s not much better than the SP 500 alone, in terms of risk, this 60/40 portfolio only had 37 negative quarters with a standard deviation of 14.45 percent.

That may not sound like much, but it is indeed a free lunch. This portfolio returns at a higher rate with less risk using the simple concept of diversification.

Reducing Risk

When I talk about diversification, I often get told that it’s been irrelevant over the last 10 years, particularly during the global credit crisis in 2008-2009.

Sure, you can see the  benefits of diversification clearly when you’re focused on different types of stocks. But in times of large systematic risks to the stock market (like what we’ve seen during the last five years), the value of diversification among equity asset classes can often go away.

So while it is still a valuable exercise to carefully plan your equity portfolio to take advantage of a free lunch where you can, the real power of diversification comes in the form of risk reduction when you start to mix stocks and bonds.

Let’s compare the 60/40 stock portfolio we built above (Portfolio C) to a portfolio where we add 40 percent in bond exposure.

Remember that Portfolio C generated a return of 11.21 percent with 37 negative quarters and a standard deviation of 14.54 percent. When we blend in a 40 percent allocation to bonds (in the form of the Barclays Capital Aggregate Bond Index), creating Portfolio D, we get a return of 10.4 percent. That’s not much lower than the all-stock portfolio, and we reduce the number of negative quarters to 35.

But the real impact is in the risk reduction we see in the form of a much lower volatility as measured by standard deviation at 9.48 percent. In other words, the ups and downs of Portfolio D will be much less sharp than Portfolios A, B, and C.

While I’m not suggesting that this portfolio is right for every individual or serves as a predictive model, the historical data at least show how being diversified can give you a way to protect yourself from many of the random events that have ruined fortunes.

Plus, diversification allows you to position yourself to take advantage of the returns that equities tend to deliver, balanced with the safety that high-quality bonds provide.

Article source: http://feeds.nytimes.com/click.phdo?i=b9b51585aed35f5609003e2be6b2c179