Stock Market Diversification Works! The Proof

by Silicon Valley Blogger on 2008-07-2224

To make money in the stock market, all you need is a proper asset allocation and time.

If you’re nervous about the stock market recently, you’re not alone. Your anxieties over your investments may be attributed to several reasons.

  • Could you be overexposed to the stock market?
  • Is your portfolio too concentrated in just a few asset classes?
  • Have you been investing for only a short period of time?

If you agreed with any of these points, then your concerns may be justified. But fear not! By reviewing past stock market performance and by appreciating the evidence put forth by long-standing investment principles, we should be able to develop portfolios that are less vulnerable to market swings and which can afford better returns over time.

I know some people who will never put their money in the stock market, arguing that “it’s just like gambling.” I get into some in depth debates with them about this, but to no avail — some people just equate stock market risk — or maybe any investment risk for that matter — to gambling risk, which is the worst kind of risk since the odds are set against you.

True, there is risk with participating in the stock market, but this is something you can easily control and manage when you take a few strategies into consideration. You won’t need a doctorate in economics to become convinced that these strategies work: the historical performance of market portfolios can speak for themselves. From my studies and experience, I discovered that I’d do well with the stock market if:

#1 My investments are well-diversified and have a reasonable asset allocation. (Diversification)
#2 My investments are subject to a long enough time horizon. (Time)


Let’s check out some numbers behind these statements made available to us by the Motley Fool.

How Diversification and Asset Allocation Affect Your Investment Returns

Over the last 35 years, here were the annual returns and standard deviations (among other measures) for 4 different asset classes: U.S. stocks, foreign stocks, REITs and Commodities. If you had placed all your funds in any one of these asset classes, it’s clear that you wouldn’t have done as well as you would have if you had instead divided your money into four equal parts and placed each 25% portion into each of the asset classes to create a mixed portfolio comprised of all 4 asset classes.

1972 – 2007 U.S. Stocks International Stocks Real Estate Investment Trusts Commodities Four-Asset Portfolio
Return* 11.19% 11.75% 13.01% 11.65% 13.22%
$1 turned into… $45.50 $54.53 $81.79 $52.81 $87.31
Standard deviation 17.02 21.66 17.37 24.52 11.00
Sharpe ratio 0.39 0.35 0.48 0.34 0.68
Worst 1-year return -26.45% -23.20% -21.42% -35.75% -12.77%
Worst 3-year return* -14.56% -17.00% -10.49% -9.58% -0.56%
Worst 5-year return* -2.31% -2.61% 3.29% -4.53% 3.34%
Worst 10-year return* 5.91% 4.30% 9.14% 2.11% 8.74%

*Compound annual total return.
Source: Roger C. Gibson, Gibson Capital Management. Large caps from S&P 500; REITs from NAREIT Index; international from Europe, Australasia, and Far East Index; commodities from Goldman Sachs Commodity Index.

Through this example, we see that the use of asset allocation to produce a diversified portfolio has improved returns over time, as well as limited the portfolio’s downside. This 4 asset portfolio gives us:

  • A decrease in volatility (as evidenced by a lower standard deviation),
  • A higher risk-adjusted return (represented by the higher Sharpe ratio),
  • Much better returns across the board for the worst case scenarios (worst 1 year, 3 year, 5 year and 10 year returns).

You can see fairly similar results when you review this table, which swaps out commodities for U.S. small stocks in the asset class comparisons:

1972 – 2007 Large Cap U.S. Stocks International Stocks Real Estate Investment Trusts Small Cap U.S. Stocks Equal parts of 4 asset classes, occasionally rebalanced
Annual Return 11.19% 11.7% 12.9% 14.3% 13.1%
Standard deviation 17.02 21.66 17.4 22.5 15.7
Worst 1-year return (26.45%) (23.2%) (21.4%) (30.9%) (22.5%)
Worst 3-year return (14.56%) (17.00%) (10.49%)

(16.7%) (9.5%)
Worst 5-year return (2.31%) (2.61%) 3.29% 0.6% 4.8%

We’re seeing similar conclusions here as those put forth in my previous article on foreign stock allocations as well as this article on the seven-asset portfolio (at Seeking Alpha), that concludes that you’ll get the best diversification benefits by incorporating asset classes that have low correlations to each other. Some highlights from the Seven-Asset Portfolio article by professor Craig Israelsen:

#1 Diversification works (surprise surprise)! When additional asset classes are added to a portfolio, you improve returns and limit the worst one-year drawdown of the total portfolio.

#2 The major changes to a portfolio occur when commodities and REITs are added to it because these asset classes have low correlations to core equity asset classes.

When people buy foreign stocks, they think they are diversified. But the three main equity asset classes have correlations of 0.7 to 0.9. You don’t get a lot of correlation benefit from adding more equities to an equity portfolio. Cash is a good diversifier, and so are bonds. But they don’t have a very attractive long-term return. The real benefit comes when you add REITs and commodities. They have equity-like returns, but low correlations … and in one important way, they have lower risk than equities.

#3 An investment portfolio can be improved by being a bit more exotic.

#4 Commodities aren’t as radical as you may think since they recover much more quickly than stocks, which tend to ride on trends and momentum for longer periods of time. This means that though commodities may generally have a higher standard deviation (overall volatility), they also tend to snap away from a losing streak faster than equities do, so their worst periods tend to be less significant than the worst case scenarios presented by equities.

At this time, our portfolio does not yet carry REITs nor commodities, but my research has convinced me to incorporate these types of investments in our portfolio. I’ve actually set the stage for this by writing out my recommendations in this post: Beat The Average Investor’s Returns With The Simplest Investment Portfolio, which I consider to be one of the most important investment posts I’ve written to date. I’ll be reorienting our current portfolio to improve on our allocations based on diversification concepts I’ve learned.

Copyright © 2008 The Digerati Life. All Rights Reserved.

{ 18 comments… read them below or add one }

RacerX July 22, 2008 at 3:22 pm

Also…nothing wrong with being a contrarian!

Markets swing back and forth and at either extreme there are great opportunities!

Sam July 22, 2008 at 11:08 pm

Ello!

Agree with your subject. The key to making money with riskier investments such as the stock market is to diversify your investments. That way, you are almost certain to have some investments that will do well when others are not doing as well. In addition, you should also expect to diversify your portfolio among different types of investments. For example, your investment portfolio should generally be a mix of different kinds of investments, such as stocks, bonds, and short-term assets like CDs or money market funds.

PersonalBudgetTraining July 23, 2008 at 6:40 am

I think your tables could be broken down more, especially in the area of international stocks. You could have Asia, Europe and Latin America and you would find a whole different return for each.

Timing is very important. An average return really doesn’t tell a lot to me. If the average return was 10% over a five year period, it would not include the fact that the market took a dive for a year, but rebounded dramatically. If one was able to invest when the market was down, you would have a great return.

J July 23, 2008 at 7:09 am

Does the worst 3-year return of -0.56% for the 4-asset approach seem too low of a loss?

Silicon Valley Blogger July 23, 2008 at 12:42 pm

Great points!

@RacerX, I love being a contrarian. It’s one of my favorite investment strategies which I’ve used over the last 20 years as an investor!

@Sam, I’d add that I made a point in this article to say that a portfolio should actually include REITs and Commodities as well. From the long term numbers I’m seeing, these asset classes will boost your portfolio’s long-term performance while controlling its downside further!

@PersonalBudgetTraining, timing is great but in the long term, timing may not be as important. Although getting out of the market may be more of a tricky dilemma as timing can be a factor on your returns once you begin withdrawing from the market (say upon retirement). The key is to rework your asset allocation accordingly as you prep for your retirement by moving your portfolio into more conservative investments as you approach your withdrawal dates.

@J, a 0.56 loss sounds mighty low yes, but those are the numbers that Motley Fool reported. I am inclined to believe they are accurate.

James - Forex Trading Blog July 25, 2008 at 12:56 am

Nice post.

My two golden rules are as follows;

1. Invest in companies that are growing profits year after year and are likely to continue to do so. Then buy when oversold or after they’ve been dragged down with the rest of the market.

2. Have a diversified portfolio but have a slight bias towards hot sectors. For example, oil and mining companies were popular last year and property companies had a good few years before that when property prices were rising.

Jim R. July 25, 2008 at 7:13 am

Good approach to stock market investment. Unless you are a day trader, diversifying with a long-term view in mind will bring some of the best and safest returns. When diversifying, pay close attention to the business “sector”. Investing in multiple stocks across the same sector is not really diversifying.

Jeff July 25, 2008 at 9:12 am

On the first table, I’m not sure how putting 25% into each of the 4 asset classes actually has a better return than the best individual asset class. I would think it would be the average of the four asset classes..unless I’m missing something?

Silicon Valley Blogger July 25, 2008 at 9:21 am

Jeff,

I’m not a financial math expert, but here’s how I understand how the numbers work:

The resulting rates of return aren’t from taking averages, it’s from allocating equal amounts from the different asset classes into one portfolio, then rebalancing it on a regular basis, usually once or twice a year. Since returns fluctuate throughout time, the resulting overall portfolio return may be different from just taking averages.

The mixed portfolio is “managed” throughout a given period and in that period, individual asset classes may have varying returns from what you’re seeing in the table. As time goes on, returns are also further compounded thereby adding to discrepancies you see in the table.

If anyone else can explain how these results come to be, we’d love to hear about it — but the Motley Fool has published more than one article with these numbers.

Bullish Bankers July 25, 2008 at 11:57 pm

Great article, I love the charts showing investments over time. I think that diversification really is the only free lunch, so it’s important to stay diversified, not getting side-tracked by potential gains from some one-week runner.

Dividend Growth Investor July 26, 2008 at 3:06 pm

Great article.. My main problem is that I don’t hold any reit’s in my retirement accounts because they are not offered. I own it in taxable accounts :-(
Do you have any recommendations on commodity and reit etf’s or mutual funds?

Silicon Valley Blogger July 26, 2008 at 4:06 pm

@Dividend Growth Investor,

Yes, please see my article on the simplest portfolio that you can build that is also well-diversified. The model I use in that article is only a sample, but the asset classes and funds/ETFs used are some I’d consider owning.

shadox July 26, 2008 at 9:06 pm

Yup, diversification works.

I have been thinking about putting some money into commodities for a long time, but these days I get the sense that commodities are in a little bit of a bubble phase, so I am going to sit this out.

On my blog a while back I created an interactive calculator for calculating diversification benefit for a portfolio of your choice. Check it out and tell me what you think:

http://moneyandsuch.blogspot.com/2008/04/calculate-your-diversification-benefit.html

Silicon Valley Blogger July 27, 2008 at 6:38 pm

Thanks Shadox!

Great tool you have there. I like the dynamic demonstration that the tool affords, by showing you how your risk and returns are affected by your asset allocation. Nice way to see things shift “on the fly”!

Enginerd August 5, 2008 at 4:25 pm

REITs pay most of their return in dividends, and those are typically taxed as ordinary income. I’m not completely sure how commodities are taxed, but I thought they were taxed higher than equities.

If the investments aren’t being done in a tax-sheltered account (and I’m assuming US investors here too) this is important to consider. That extra 10% tax on REIT gains wipes out the additional return they have over equities.

I think this is a good strategy overall, especially as it lowers volatility, just saying there are other details to consider.

Jason May 27, 2009 at 1:22 pm

Diversification certainly works but there is a time where you should exit the market all together when diversification usually has the buy low / sell high mentality attached to it. I think more important is strategy – being long and short when it is appropriate to do so. Strategy > Diversification.

REIT Wrecks November 29, 2009 at 1:40 pm

I have a lot to learn about asset allocation, so I appreciate this post, but I’m not sure about the low correlation of REITs to stocks. REITs got crushed in 2008, right along with equities. I would say direct property investments are less correlated and a better way to go, but it’s also true that most investors don’t have to ability/knowlege to make a direct investment in commercial property. Lot’s of people now are focused back on senior mortgage debt, since it is higher in the capital stack and theoretically safer than equity. You can buy a mortgage reit portfolio and get exposure to this asset class, but as with all reits, best to avoid those with legacy asset issues. Good luck and thanks for the informative post!

Dalia Stusse November 23, 2011 at 10:23 pm

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