Investment Diversification – A Look at the Basics

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.

 

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

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner.

Photo Credit:  Flickr