Do you believe that portfolio diversification is a recipe for mediocrity? You would not be alone. The notion that you can boost a portfolio's return by investing in multiple asset classes (some of which will probably show negative returns at any given time) is counter-intuitive. Surely you would be better putting all your money in equities, the long-term winning asset class?
But diversification is a smart decision for growth-oriented and risk-averse investors, according to award-winning United States author and financial planner Roger Gibson, a speaker at the inaugural meeting of the Portfolio Construction Forum researchers' round table recently.
The challenge is to stick with a diversified portfolio through bull and bear markets and avoid the temptation to cash up or follow the crowd into the latest "hot" investment. Gibson said: "At any point there's a good chance that an investor will feel pulled through fear or greed from a rational strategy."
He looked at individual and combined returns from four asset classes for the 30-year period to 2001. The asset classes and annual compound returns in US dollars are as follows:
Commodities, 10.55 per cent.
A portfolio invested one quarter in each of the asset classes (a four-asset-class portfolio) would have outperformed each of the individual asset classes, returning a compound 12.98 per cent a year, In fact, Gibson showed that the four-asset-class portfolio's returns and volatility were better than a 50:50 combination of any two asset classes. And the four-asset-class portfolio also beat three of the four possible 1:3 combinations of asset classes. When it came second, it was very close: a 12.98 per cent return and 11.23 per cent standard deviation (volatility) compared with the winning 13.10 per cent return and 10.94 per cent volatility.
Why? The key to the four-asset-class portfolio's success was its lower volatility, Gibson said. It was the steadiest performer, having the fewest negative calendar years (five, against six to eight for other combinations) and never having the highest return in any one calendar year.
The diversification benefits shown by Gibson did not end there. Incredibly, a portfolio invested evenly across the three lowest-return asset classes (commodities, US shares and non-US shares) resulted in a 12.71 per cent return and 14.48 per cent standard deviation - better than the return (12.49 per cent) and volatility (15.42 per cent) of the winning asset class, US real estate securities.
"Volatility reduction is triggering return payoffs," Gibson said. However, he added: "The price you pay is a willingness to live with returns that are dissimilar to every natural benchmark."
That is, smart investors should have not only a rational strategy but also the discipline to stick with it. And, as Gibson pointed out, many US investors don't. From 1984 to 2000, the average annual return for US equity funds was 14 per cent. But equity fund investors achieved an annual average of just 5.3 per cent - because they were not invested every day in that period, thereby missing some of the best rallies.
Gibson noted that his analysis might be new but the principles of diversification it highlights are not. These principles were promoted more than 2500 years ago in the Old Testament. "Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve." And Shakespeare showed in The Merchant of Venice that he understood diversification: "My ventures are not in one bottom trusted, nor to one place, nor is my whole estate upon the fortune of this present year. Therefore, my merchandise makes me not sad."
My advice? Gibson's analysis is in the process of being repeated for Australian investors' asset-class choices. The results are not in yet, but I am pretty sure we will get similar results. Diversification may not be sexy, but it wins the marathon investment race in the long run. If you are interested, amazon.com stocks Gibson's book - a Christmas gift to yourself, perhaps.
Graham Rich is an independent funds analyst and publisher of www.portfolioconstruction.com.au
