Diversification is a widely prescribed investment strategy, and for good reason. It is essential for lowering inherent risk in a portfolio while optimizing long-term returns.
There are a number of asset classes an investor can include in their portfolio to achieve diversification. They include stocks, bonds, annuities, and alternative investments like real estate. However, diversification doesn’t just mean investing in several asset classes, it means investing in assets that move differently from each other.
In his landmark research in the 1950s, Harry Markowitz established that the risk level of a portfolio is not just in the sum of its components, but also their correlations. Do their prices go up and down together or do they move independently of each other? By building a portfolio of assets that have low correlations, an investor will achieve better risk-adjusted returns long term.
Consider research by Vanguard on the success of various stock versus bond portfolios between 1926 and 2018. Stocks and bonds have low correlation, so what are the benefits of investing in each individually versus combining the two? Starting with stocks, researchers found that over the 93-year period, a portfolio that was 100 percent stocks earned an average annual return of 10.1 percent. However, it suffered losses in 26 out of the 93 years, with its worst loss being a 43.1 percent dip.
What about a portfolio that was 100 percent bonds? In that 93-year period, this portfolio earned an average annual return of 5.3 percent but only had 14 loss years, the worst of which was a mere 8.1 percent.
Both examples feature portfolios that were not diversified by asset type. From their returns, it is evident that stocks alone had a higher return but at a much higher risk of loss, while bonds alone had a lower return but a lower risk of loss. By blending both asset types in a portfolio, an investor can achieve both good returns and low risk levels. That is the essence of diversification.
To show this practically, the researchers at Vanguard put together a portfolio that was 60 percent stocks and 40 percent bonds. They found that this portfolio achieved an 8.6 percent average annual return and had only had 22 down years, the worst of which was 26.6 percent. Overall, that’s a much better risk-adjusted return.
While the example above focused on stocks and bonds, investors today have many more options with regard to the asset classes they can include in their portfolios. In each asset class they allocate to, investors should also apply the principles of diversification. For example, if they allocate 20 percent of their funds to stocks, they can buy different types of stocks. They can mix large-cap stocks with mid- and low-cap stocks or buy stocks of companies in different industries. They can even diversify geographically, buying stocks of companies in different countries.
Similarly, there are different types of bonds and annuities. With bonds, there are short- and long-term Treasuries as well as federal, state, municipal, and corporate bonds. For annuities, there are fixed and variable annuities, among other classifications. There are also alternative investments like real estate, precious metals, private equity, and cryptocurrencies. Investors who want to diversify their portfolios should talk to a financial advisor to guide them on the mix that is most appropriate for them, given their current position, goals, and risk tolerance.
