The Power of Diversification

   

    Portfolio diversification is a broadly accepted investment tactic that has been in use in its most basic form since at least the 4th century B.C. when Rabbi Issac Bar-Aha espoused the concept as a division of wealth between merchandise, land, and gold. Though portfolio diversification has evolved considerably since then, the end result remains the same: A reduction in volatility that mitigates losses, particularly in times of uncertainty. Unfortunately, as outlined in our recent report, The Risks of DIY Investing, many investors struggle to put the concept of diversification into practice.

    Burton Malkiel and Charley Ellis identify three aspects of diversification in their work, The Elements of Investing: Across individual assets, across asset classes, and across time. The first is the most straight-forward aspect of diversification and is commonly achieved by investing the equity allocation of a portfolio in many stocks rather than in a single security, for example. The third aspect—across time—does create issue for many investors who may try to “time” the market. However, it is the second aspect that creates the most confusion for investors when constructing portfolios.

    To illustrate, consider that most investors in the United States hold only a small fraction of their equity holdings in non-U.S. stocks—despite the size and breadth of the global marketplace. A recent study by the VanguardGroup indicated that more than 51% of the global equity market is made up of more stocks outside the United States. By contrast, the average American investor holds only 27% of their assets in non-U.S. stocks. This massive underweighting of foreign stocks may have been a benefit over the last five years; however, over the average investor’s time horizon, this under-weighting of foreign stocks subtracts meaningfully from returns.

    A similar tale exists in the bond markets where the majority of bonds are issued by governments and corporations outside the United States. Even after adjusting for currency of issuance (foreign entities can issue bonds in local currency or in U.S. Dollars), half of the bond market is still domiciled outside the United States. Foreign markets are not perfectly correlated with U.S. markets and consequently exhibit different risk and return profiles. It is this combination of differing risk and return profiles that makes portfolio diversification such a powerful tactic.

    A review of annual returns, by asset class, further underscores the point. In any given year, the leading asset class is rarely the best performer in the following year. The relative performance of individual asset classes changes constantly, ranging from the best to the worst asset class for any given year. The exception in this year-to-year examination of the markets is a diversified portfolio composed of each of the asset classes. Because this portfolio is comprised of all asset classes, it draws benefit from the contributions of each. In most years, the performance of this diversified portfolio is within the upper third of asset classes and is rarely worse than the median. The compounding effects of this leadership position over time means that the diversified portfolio outperforms all other asset classes on a risk-adjusted return basis, if not necessarily on an absolute basis.

    To realize this outperformance, an investor must be fully invested in the market and must rebalance efficiently. As for the former, many academic papers have been written, most notably Statman in 1995, that demonstrate that dollar cost averaging is not as beneficial as lump sum investing. Those studies find that, on average, lump sum outperforms dollar cost averaging approximately 70% of the time. Think of the difference not in terms of investing or not investing but in terms of making a large allocation to cash or to securities. Framed in that manner, few return seeking investors would have a preference for a zero return asset class. This, of course, assumes that one is investing in a broadly diversified portfolio.

    As for rebalancing, it must be done in an efficient manner. Over a 10-year study, David Swensen, the Chief Investment Officer of the Yale University Endowment, found that efficiently rebalanced portfolios earned an average of 0.4% more per year than the same portfolio that went without rebalancing. There are many different theories on when and how to rebalance (quarterly, annually, when investments are up over a threshold, etc.); however, The Vanguard Group, along with other academics, have found that the optimal approach to rebalancing is a combination of a timing metric (e.g. quarterly) with a deviation threshold (e.g. +/- 10% of the target allocation). Combining these two helps to control for transaction costs as well as improving risk-adjusted returns.

    Such a simple concept, diversification may now seem like an almost impossible goal beset by behavioral biases, investment timing, and rules for rebalancing. To address these challenges, Wintrust Wealth Management developed its Multi-Asset Strategy program utilizing an advanced risk-based asset allocation strategy to tailor diversified portfolios for individual client needs. In addition, the program includes a robust rebalancing process to help maximize tax efficiency and risk-adjusted returns.