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Living With Diversification

| February 13, 2019

Diversification is widely respected as an efficient and responsible way to build and preserve wealth. Theoretical support for diversifying investments stems from Modern Portfolio Theory, which showed how the risk-reward performance of an investment portfolio could be improved by including different asset classes. A diversified portfolio allows an investor to take advantage of a variety of return sources, and spread out risk exposures. Unfortunately, while diversification may be an important pillar of portfolio management, it poses challenges with respect to investor psychology. It turns out that actually "living with" diversification can be difficult.

To see both the advantages of diversification and the ways in which it cuts against an investor's natural tendencies, let's look at the performance of two different investment portfolios over the past 20 years. The first portfolio is just the U.S. stock market over that time; The second is a diversified portfolio that comprises U.S. large cap stocks (40% of the portfolio), U.S. small cap stocks (15%), foreign stocks (15%), U.S. bonds (20%), and REITs (10%), and is rebalanced once a year to maintain the investment allocations. Exhibit 1 shows that the diversified portfolio outperformed the stock market portfolio over the past 20 years. Just as importantly, the diversified portfolio exhibited lower risk over the period as evidenced by lower volatility, lower drawdowns, and lower value-at-risk metrics.

Looking at the annual returns in Exhibit 2 provides some clues as to why diversification can be difficult for investors. Notice that the stock market was down in 5 years over the period we are examining. In every one of those years, the diversified portfolio also had negative returns. So investors would be disappointed if they were hoping that diversification would prevent losses when the market dropped. What about the years when the market went up? Out of the 15 full calendar years in which the stock market went up, the diversified portfolio lagged the market in 12 of those years. This result isn't especially surprising, but it is a cause for investor unhappiness. To an investor, the natural thought is: "When the market goes down, my diversified portfolio still goes down, and when the market goes up, my diversified portfolio doesn't go up as much." 

Living with diversification means accepting this reality: A diversified portfolio will likely go down when the market goes down, and will likely lag when the market goes up. While this may feel disappointing, investors have to remain objective and make decisions based upon evidence, not emotions. The arguments in support of diversification are not merely academic. In the exhibit above, it is important to appreciate that the diversified portfolio outperformed the market by an average of 6.3% in years in which the stock market fell. Investors may be displeased when they are losing money, but they must remember that not all losses are the same. The ability of a diversified portfolio to preserve capital and outperform in down years is an important part of its long-term appeal. Keeping this in mind when reviewing portfolio performance may help investors overcome the difficulty of living with diversification.

Disclaimer: If it wasn't clear from the the blogpost... asset allocation and diversification are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss.