Money managers and financial advisers often disagree on the direction of the economy and where the stock market is headed. But they generally agree that diversification, when done properly can greatly reduce your risks. Intuitively, this is because when you hold assets that move in different directions at different time, you end up smoothing out the ride.
What’s less intuitive is that by combining diversification with regular portfolio re-balancing, you can also improve your return above and beyond the return achieved in any of the assets you hold in your portfolio.
Huh?! Yes, you can achieve returns that are higher than any assets in your portfolio using a well-designed diversification and portfolio re-balancing plan. The example below illustrates this in more details.
Diversification Using Stocks and Bonds
Consider a portfolio invested in two ETFs: SPY, the S&P 500 stock ETF, and IEF, the 7-10 years US treasury bond ETF. The time frame is January 2007 to the end of January 2015. Now look at the chart below.
The red curve represents $1 invested in SPY, while the green curve represents $1 invested in IEF. The blue curve represents a $1 portfolio invested 50/50 in SPY and IEF (i.e. $0.50 in SPY and $0.50 in IEF). The portfolio is re-balanced at the end of every year, so it holds 50% in SPY and 50% in IEF on January 1st of every year.
You can see the impact of the 2008 financial crisis on stocks (SPY) and the recovery thereafter. Also note how IEF behaved during the financial crisis. Government bonds were seen as the safe place to be, so while the bottom was falling out of stocks, bonds rose rapidly. Note also that bonds continued to go up for the rest of the time frame. This was fueled by the Federal Reserve quantitative easing program which pushed long term interest rates downwards. In fact, the total return on both SPY and IEF over the time frame (including dividends) was about the same at roughly 68%.
Diversification Means No Blues For You
The blue curve is what’s truly exciting. 🙂 Observe the following:
- The ride was much smoother than SPY, and somewhat similar to IEF.
- The portfolio return was higher at 82% than either IEF or SPY, both of which returned 68%.
We got 1% more in annualized returns with the 50/50 portfolio (7.7% vs. 6.7%), while both the maximum drawdown and standard deviation were far better than SPY. Meanwhile, the Sharpe ratio was just about as good as IEF and 3 times better than SPY.
In other words, our boring 50/50 portfolio beat SPY on all four important performance measures. We got higher returns, lower drawdown, lower volatility and higher Sharpe. Sweet.
But How Can That Be?
IEF is uncorrelated with SPY for the most part (not always), because it’s a different asset class. This means that when SPY goes down, IEF may go up or may go down somewhat independently. Assets are correlated when they move up and down together. Conversely, assets are uncorrelated when they usually don’t move in the same direction at the same time. Asset can also be inversely correlated and move in opposite direction, as SPY and IEF were for most of 2008.
It’s also important to understand that the correlation relationship between assets can change quickly over time. For example, two assets can be uncorrelated for a while, and then become highly correlated. This happened with several types of assets during the 2008 financial crisis for example.
To achieve the magic of diversification, you want uncorrelated assets in your portfolio. Buying 50 stocks in the same industry will not get you there since these are usually highly correlated. On the other hand, a portfolio that includes US bonds, US stocks, foreign stocks, foreign bonds, commodities and real estate will tend to achieve the goal of diversification much better.
How can we get higher returns? This is the magic of re-balancing. To make money, you need to buy assets when they are cheap, and take some profits by selling them when they get expensive. Re-balancing forces that discipline.
Consider what happened at the end of 2008. IEF went up and SPY went down in our 50/50 portfolio. So to re-balance and bring the proportions back to 50/50, we sold some IEF and used that money to buy some SPY. In other words, we sold relatively expensive IEF and bought (much cheaper) SPY. That’s what you want: accumulate more of the cheaper asset and take some of the profits on the expensive ones. Do this for several years, and as beaten-down asset prices recover (buy low), or expensive assets go down (sell high), you end up with a winning formula. Meanwhile, if you are dead wrong with an asset that collapses in your portfolio (for example, the stock of a company that goes bankrupt), you also limit the collateral damage to your portfolio (reduce the drawdown).
So what rocks in all this? Understanding how diversification works in practice and at an intuitive level is possibly the most fundamental rule of long term investment success. This, in my humble opinion, is a good reason to throw a party and celebrate with your favorite rock band.