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Investment Diversification – A Look at the Basics

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Investment Diversification is one of the basic tools  of building a sound investment portfolio. Diversification is the fancy name for  the advice your mother might have given you:  Don’t put all of your eggs in one basket.  This is the basic tenant behind asset allocation, a key diversification tool.

My fellow finance blogger Ken Faulkenberry defines investment diversification as follows:

“Investment portfolio diversification is a portfolio strategy combining a variety of assets to reduce the overall risk of an investment portfolio. “  

A basic look at diversification 

Based on Ken’s definition you could use stocks, bonds, mutual funds, ETFs, private equity and a whole host of assets and asset types in building a diversified portfolio.  In the examples that will follow I am going to limit this to mutual funds investing in stocks and bonds.  Please note that nothing that follows should be construed as advice or a recommendation of any kind.  The mutual funds and allocation percentages used are for example only. 

Let’s start with an investor with $100,000 to invest.  Let’s go back in time to January 1, 2000.  One thought would be to pick a fund that invests in a variety of stocks.  Perhaps the Vanguard 500 Index Fund (VFINX) is a good choice.  How much would an investment of $100,000 have grown to by December 31, 2009, the end of the press has deemed the lost decade?  The answer is that your $100,000 investment would have shrunk to $90,165 for an average annual loss of 1.03%.  Truly a lost decade for this investor.

Let’s say this investor added the following funds to his portfolio:

  • Vanguard Small Cap Index (NAESX)
  • Vanguard Mid Cap Index (VIMSX)
  • Vanguard Total International Stock Index (VGTSX)

How much would an investment of $100,000 invested equally in each of these four funds have grown to by December 31, 2009?  (We are assuming no taxes or rebalancing in this and all examples in this article)  The answer is $137,511.  This is $47,346 or about 52% more than an investment of our investor’s cash only in the Vanguard 500 Index.  Let’s look at the average annual investment returns for each of these funds for the period 1/1/2000 – 12/31/2009:

Vanguard 500 Index -1.03%
Vanguard Small Cap Index  4.36%
Vanguard Mid Cap Index  6.13%
Vanguard Total International Stock Index 2.29%

 

While the average annualized return of 3.23% over the course of the decade is nothing to write home about, it does illustrate the potential benefits of diversification.

Let’s add some bonds 

Some say building a portfolio is much like cooking, which is one of my favorite pastimes.  My motto in the kitchen is “… when in doubt add more wine…”  Sadly wine and investing are not a good mix.

What if we added some bond funds to the mix?  In this case let’s add the following funds:

  • PIMco Total Return (PTTRX)
  • T. Rowe Price Short-Term Bond (PRWBX)
  • American Century Inflation Adjusted Bond (ACITX)
  • Templeton Global Bond (TPINX)

If we now divide the investor’s $100,000 investment equally among the four equity funds from the prior example and among these four bond funds, by 12/31/2009 the $100,000 investment has grown to $174,506 or almost double what an investment of $100,000 in the Vanguard 500 Index Fund alone would have yielded.  The portfolio’s average annual return was 5.72% for the decade.

Looking at the average annual investment returns for each of the bond funds for the period 1/1/2000 – 12/31/2009:

PIMco Total Return 7.65%
T. Rowe Price Short-Term Bond 4.89%
American Century Inflation Adjusted Bond  7.20%
Templeton Global Bond 10.66

 

The impact of diversification

Again this example was based on eight funds weighted equally with no rebalancing and the reinvestment of all distributions.  This was an unusual decade in that bonds largely held their own or outperformed equities.  It is likely that if we performed this same analysis for the ten years ended December 31, 2019 the results would look different.  None the less there are a few things we can take away from this analysis:

  • The decade 2000-2009 was a poor one for large cap stocks as illustrated by the use of the S&P 500 index fund.
  • Small, mid cap, and international equities outperformed domestic large cap stocks.
  • Diversifying the equity holdings in this example boosted overall portfolio return.
  • Bonds were aided by generally declining interest rates and lower volatility than equities.  Both of these factors helped their overall return for the decade and really boosted our hypothetical portfolio.  Bonds in general have a relatively low correlation to equities which assisted in mitigating the volatility of our portfolio and enhanced returns.
  • Even in this “lost decade” asset allocation helped enhance return.

What does this mean for the future? 

Clearly the period used in the analysis was unique one, a decade that contained market declines (as measured by the S&P 500 Index) of 49% from March of 2000 through October of 2002 and 57% from October of 2007 through early March of 2009.  However it seems that market volatility has become the norm rather than the exception so the current decade will likely be an interesting one as well.  A few lessons we can take forward:

  • Diversification reduces risk.
  • Diversification among assets with low correlations to one another further reduces risk.
  • Diversification is important because we have no way of knowing which investments or asset classes will perform well or poorly or when.

Please feel free to contact me with your investing and asset allocation questions. 

For you do-it-yourselfers, check out Morningstar.com to analyze your investment holdings and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you. 

Note that all data used in this article was generated via Morningstar’s Advisor Workstation.

Photo Credit:  Flickr

 

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Comments

  1. Good post Roger! I think a lot of times we as investors can miss the boat on being appropriately diversified. The thought can be…well, I own 5 or 6 stocks so I am diversified. It’s not that simple, as you well know, and when done right can be a great way to try and further grow & protect your portfolio.

    • Roger Wohlner says:

      Thanks for the comment. Owning a number of stocks is diversification to an extent. Along with diversification investors will want to look at other issues such as correlation of holdings to ensure that they achieve the desired level of risk control as well.

  2. Thank you Roger. I feel honored that you have quoted me. I want to expand on this quote: “Based on Ken’s definition you COULD use stocks, bonds, mutual funds, ETFs, private equity and a whole host of assets and asset types in building a diversified portfolio”. I have emphasized COULD because many options would not reduce the overall risk or a portfolio.
    The goal is to combine assets in a way that will reduce the overall risk of the total portfolio. This does NOT mean more diversification is better than less. Over diversification can actually add risk to a portfolio.
    Adding overvalued assets could add risk to a portfolio. Placing assets with poor risk/reward expected returns does not make up for the fact it is additional diversification. For instance, I do not believe most bonds lower the risk of a portfolio at today’s prices.

    • Roger Wohlner says:

      Thanks for the comment Ken. I agree totally. The post was an illustration of the potential benefits of diversification and I felt that the “lost decade” was a great laboratory for doing this. About 13 years ago I was working with a corporate exec whose company had paid for me to do a financial review session with their senior managers. He engaged my services beyond that for a full review of his situation. He felt he was diversified in that he held 19 different mutual funds, all large cap. All of them held Microsoft, 18 of them held Cisco and so on. This was early 2000, right before the dot com bubble burst. I did not work with him beyond that and was not sure if he followed my suggestions to diversify. What a potential disaster waiting to happen. To your point a lot of holdings did not equal a well-diversified portfolio there by any definition.

      In your comment you are also (I think) hinting at the need to take the correlation of your holdings with each other into account as well, this will likely be the subject of an upcoming post as well.

  3. David Smith says:

    Thank you for the informative post. Correlation is a helpful quantity for assessing diversification. Identifying assets with strong returns is easy, but it is not easy to know if a portfolio of such assets generates any risk advantage. Correlation calculations can help answer that question.

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