Finance 101

Diversification. It’s the all-weather investing strategy

September 26, 2014


Diversification. It’s the all-weather investing strategy

Finance 101

We’ve seen the rise in popularity of indexing and index ETFs? Diversification is a big reason– even if some investors don’t quite get how it helps them.

There are some do-it-yourself investors who have interpreted this ‘new testament’ to mean that we should all just hold the S&P500 and profit. However, in addition to the mounting evidence that even monkeys could beat cap-weighted indices there is also the significant impact of excessive volatility from holding an insufficiently diversified portfolio to consider.

Many people believe that volatility is just a short term issue and doesn’t hurt their returns over the long run. In fact some even believe it benefits them, after all the higher the risk, the higher the reward in the end right? The reality is, excessive volatility has an ongoing negative effect on compounding returns. This effect is less pronounced when you’re accumulating assets and have a long investment horizon but can be extreme when you are living off your investments in retirement. Regardless, and perhaps counter intuitively, excess volatility provides little tangible benefit to long-term returns as we will demonstrate.

Reducing volatility through diversification isn’t hard to do

If you (or your portfolio manager know what you’re doing, diversification is actually easy to achieve.

Take the much maligned 60/40 stocks/bonds portfolio. These days many people seem to feel there’s no good reason to hold bonds. But over the long run this portfolio has had a standard deviation that is 45% lower than just holding stocks and an average return that is just 0.7% lower.

The worst draw-down on a pure stocks portfolio was a whopping 40% (are you sure you can stomach that?) while the 60/40 only dropped a maximum of 22%. For less than 1% higher return the stock investor had to stay the course, accept significantly more volatility and greater drawdowns.

As a further comparison, I’ve created an even more diversified portfolio that is 30/30/30/10 stocks/bonds/REITs/commodities. Again this is a fairly naive portfolio simply based on total indices, but with this added diversification we get even lower volatility while actually outperforming (slightly) the pure stock portfolio.

Portfolio Return Volatility Maximum Loss
Stocks 10.35% 18.27% -40.61%
60/40 9.66% 11.80% -22.04%
30/30/30/10 10.48% 10.78% -25.05%
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Volatility can be a real drag on performance

So, if all these portfolios have comparable performance, does it really matter how much volatility they each had? This is much easier to illustrate if we picture our portfolios during retirement. Here we have the same portfolios now starting at $1M with a $50k withdrawn each year. The pure stocks portfolio doesn’t make it to the finish line, while the 30/30/30/10 portfolio actually increases in value significantly to $2.5M. So now we see just how significant the effect of volatility drag can be.

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Stop being your own worst enemy when it comes to investing

So, you may ask, what if I’m still accumulating assets, I can go all in on stocks, right? I suppose, but why would you? We’ve already shown that increased volatility is giving you negligible gains. Why go all in on one asset class when a diversified portfolio can work during all seasons? It’s an “all weather” strategy.

Besides, volatility drag is only one reason for a diversified portfolio. Investor emotions and tolerance for downside risk is a far bigger one. Year after year, investor studies show that it is investors themselves who are their own worst enemies, typically performing a full 4% points (imagine 4% vs. 8%) worse than the investments they hold based on getting in and out of investments at the wrong times. In other words, following a strategy you can stomach throughout all seasons could be worth as much as 4% to your average returns, something that could effectively double your returns.

So while the idea of just buying-and-holding the market has gained significant popularity in part due to the rise of ultra low-cost index ETFs, the numbers, historically speaking, tell a very different story. Diversification is still a good thing and taking on excessive volatility is largely unnecessary.

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