Should You Diversify?
“There is no free lunch” is a popular saying in economics and finance. It means you can’t get something for nothing. But there is an exception to this rule and it is called diversification. Introduced in the 1950s, Dr. Harry Markowitz demonstrated that investment returns could be increased while simultaneously reducing risk by adding uncorrelated assets to an existing portfolio. “Uncorrelated” means that prices move in different directions. Diversification is the magic that happens when more and more uncorrelated assets are mixed together in a portfolio. The more uncorrelated assets, the greater the diversification.
Why wouldn’t you diversify?
Many pundits make a living by forecasting the next winners. Some see value stocks performing best in the future while other see emerging markets or commodities. If these forecasters stick to their stories long enough, they increase the chances of being right. In a classic Financial Analyst editorial, Jack Treynor wrote about the “Buffalo Dance” where a tribe of Indians did a dance every Spring to bring the buffalo home, and it always worked, but sometimes the dance went on for months and months.
In other words you wouldn’t diversify if you could forecast the returns of asset classes or individual stocks and bonds, but that is very difficult.
Why would you diversify?
Wall Street Journal reporter Jonathan Clements advises: We should build globally diversified stock portfolios, and also throw in at least a small helping of bonds. Diversification isn’t just a defense against our own lack of clairvoyance. It’s also a way to buy ourselves a little more patience, so we’re more likely to stick with the laggards—and be there to make money when they finally return to favor.
Dr. Markowitz won a Nobel Prize in 1990 for his groundbreaking Efficient Market Hypothesis. The following graph shows the idea. The Efficient Frontier is the envelope of maximum returns that can be earned for a given level of risk. The frontier moves up and to the left as diversifying assets are added, producing more return and less risk. The fact that risk is reduced is described as “mitigating the risk of large losses.”
What assets are uncorrelated?
As a general rule, different asset classes like stock and bonds are uncorrelated because their returns do not move in lockstep. The following “Periodic Table” demonstrates this idea by showing how asset classes come in and out favor. In some years U.S. stocks have been the best performer and in others they have been the worst.
Of course in the years when US stocks perform best, you’d prefer to not be diversified – you’d rather be 100% in US stocks. Investors frequently say diversification didn’t “work” in that circumstance, but the promise of diversification isn’t persistent out-performance. It’s higher expected returns for less risk. In other words, performance will be different (but not necessarily better every time) and the investment ride will be smoother. It takes many years to enjoy the benefits of diversification, so be patient.
How much diversification is enough?
We recommend the following assets for a well-diversified portfolio:
- US and foreign stocks
- US and foreign bonds
- Real estate, preferably global
- Cash (Short term bonds)
What does it cost?
Globally diversified multi-asset portfolios command high fees, generally more than 1.5% (150 basis points), but it is possible to construct such portfolios for less than .05% (5 basis points) using low cost Exchange Traded Funds (ETFs). If you pay more than .05% you should know what you’re paying for.