Client Primer: Why Diversify
The goal of diversification is not to boost performance—it will not ensure gains or guarantee against losses—but it can help set the appropriate level of risk for an investor’s time horizon, financial goals, and tolerance for portfolio volatility. At the heart of diversification lies the concept of correlation. Simply put, correlation is a measure of how returns of two assets move together (i.e., whether their returns move in the same or in opposite directions and how often).
Correlation is a number from -100% to 100% that is computed using historical returns. A correlation of 50% between two stocks, for example, means that in the past when the return on one stock was going up, then about 50% of the time, the return on the other stock was going up too. A correlation of -70% tells you that historically 70% of the time, they were moving in opposite directions—one stock was going up, and the other was going down.
When you put assets together in a portfolio that have low correlations, you may be able to get more returns while taking on the same level of risk or the same returns with less risk. The less correlated the assets are in your portfolio, the more efficient the trade-off between risk and return.
To build a diversified portfolio, an investor should look for assets whose returns have not historically moved in the same direction and, ideally, assets whose returns move in the opposite direction. That way, even if a portion of a portfolio is declining, the rest of the portfolio may be growing. Thus, you can potentially dampen the impact of poor market performance on your overall portfolio.
Another important aspect of building a well-diversified portfolio is to stay diversified within each type of investment. Within individual equity holdings, beware of overconcentration in a single stock. For instance, you may not want one stock to make up more than 5% of your stock portfolio. It is also smart to diversify across stocks by capitalization (small, mid, and large caps), sectors, and geography. Again, not all caps, sectors, and regions prosper at the same time; so you can help reduce portfolio risk by spreading your assets. If you are investing in funds, you may want to consider a mix of styles, such as growth at a reasonable price, quality growth, and aggressive growth. Similarly, if you need to increase your bond allocation, consider bonds with varying maturities, styles, and sensitivities to inflation and interest rate changes.
If you are investing in funds, you will want to consider whether they have been strong, consistent performers relative to their stated objectives and styles. Just because your investments have not been historically correlated when you choose them, that does not mean they will stay that way. Correlation can change dramatically and rapidly in volatile markets. Assets can become highly correlated, meaning their returns move in the same direction. This reduces the short-term benefit of diversification, which is what happened during the bear market downturn of 2008–2009, but it does not reduce the long-term appeal of diversification.
The Last Bear Market
During the 2008–2009 bear market, the correlations of U.S. stocks (Dow Jones Wilshire 5000) to virtually every type of asset except Treasury bonds (not shown below) increased sharply. As the chart below shows, correlations of U.S. stocks to international stocks and high-yield bonds jumped to nearly 90%. Investment-grade bonds and cash went from being negatively correlated to U.S. stocks to being positively correlated. All of this reduced the effectiveness of diversification during this period.
Correlation to U.S. Stocks
|
|
September 2008 |
February 2009 |
|
Foreign Stocks |
81% |
91% |
|
Emerging Markets Stocks |
76% |
83% |
|
U.S. High-Quality Bonds |
-14% |
29% |
|
U.S. High-Yield Bonds |
54% |
89% |
|
Cash |
-4% |
24% |
High Price of Bad Timing
Unfortunately, many investors struggle to realize the benefits of their investment strategy because they sell out of stocks when they are falling or change their investment mix to chase the returns of a rising stock market—a practice known as market timing.
Trying to time the market is notoriously difficult. A study by Dalbar has shown that investors trail the market significantly. This means the decisions investors make about diversification and when to get into or out of the market, as well as fees, cause them to generate far lower returns than the overall market. The table below (source: QAIB and Dalbar) shows returns for a 20-year period (1991–2010). Although the S&P 500 outperformed a 60/40 mix (9.1% vs. 8.8%), it did so with far greater volatility. The table also shows how mutual fund investors have fared poorly compared with their respective index (3.8% vs. 9.1%, 2.6% vs. 6.8%, and 1.0% vs. 6.9%).
January 1, 1991 to December 31, 2010
|
Investment |
Annualized Return |
|
S&P 500 |
9.1% |
|
Average Equity Fund Investor |
3.8% |
|
60% S&P 500 + 40% Barclays Bond Index |
8.8% |
|
Average Asset Allocation Fund Investor |
2.6% |
|
Barclays Aggregate Bond Index |
6.9% |
|
Average Fixed-Income Fund Investor |
1.0% |
Building a Diversified Portfolio
The investment mix (e.g., stocks, bonds, and short-term investments) should be aligned to your investment time frame, financial needs, and comfort with volatility. The sample target asset mixes below show some asset allocation strategies that blend stock, bond, and short-term investments to achieve different levels of risk and return potential.
Portfolio Returns: 1926-2010
|
|
Best 1 Year |
Worst 1 Year |
Best 5 Years |
Worst 5 Years |
Average (1926-2010) |
|
Short-Term |
15% |
0% |
11% |
0% |
4% |
|
Conservative |
31% |
-18% |
17% |
0% |
6% |
|
Balanced |
77% |
-41% |
23% |
-6% |
8% |
|
Growth |
110% |
-53% |
27% |
-10% |
9% |
|
Aggressive Growth |
137% |
-61% |
32% |
-14% |
9% |
|
Very Aggressive |
163% |
-68% |
36% |
-17% |
10% |
Note: Short-Term = U.S. T-Bills / Conservative = 50% bonds, 30% T-Bills, 14% S&P 500, and 6% foreign stocks / Balanced = 40% bonds, 35% S&P 500, 15% foreign stocks, and 10% T-Bills / Growth = 49% S&P 500, 25% bonds, 21% foreign stocks, and 5% T-Bills / Aggressive Growth = 60% S&P 500, 25% foreign stocks, and 15% bonds / Very Aggressive = 70% S&P 500 and 30% foreign stocks.
Rebalancing May Help
Just diversifying is not enough. Once you have a target mix, keep it on track with periodic checkups and rebalancing. If you do not rebalance, a good run in stocks could leave your portfolio with a risk level inconsistent with your goal and strategy.
Consider a hypothetical growth portfolio with 70% in stocks (49% U.S. and 21% foreign), 25% bonds, and 5% short-term investments in March 1992. A decade later, at the end of March 2002, the bull market of the late 1990s would have changed the investment mix dramatically to nearly 80% in stocks (64% U.S. and 14% foreign), 19% in bonds, and 3% in short-term investments. The portfolio’s risk level as of March 2002 was 12% greater than that of the target mix due to changes in the asset allocation associated with the relative returns of stocks, bonds, and cash.
By the end of March 2012, changes in the stock market would have reduced the allocation slightly for stocks to 77%, closer to the target but still significantly above it. The stock mix also shifted significantly to 61% in the U.S. and 16% in other parts of the world. The bond and short-term allocations were also off. This added to a portfolio risk level 10% higher than the target due to changes in investment mix.