A Reminder of the Benefits of Diversification In Your Investments

Barry Ritholtz shared this JP Morgan infographic and I thought it was worth a share. Remember that I'm an advisor, so this post may be a little biased! The information in this graphic has been shared many times before, but it's worth examining again. It illustrates the benefits of diversification and its theme is the basis for how I approach portfolio construction for clients.

We have all read many articles about diversification, but it's always healthy to remind ourselves why it's important. In the example above, you can see the comparisons of two hypothetical illustrations. It's important to note that you can't invest in either of these because they are showing the returns of a portfolio of indices. You can't invest directly in indices, but you can invest in index funds that, after fund expenses, will be close to the return of the index it tracks and should have similar volatility.What we see in the left illustration is a portfolio invested into 30% bonds and 70% stocks. Over an 18 year period ending in 2012, this model returned 7.43% with a standard deviation of 10.8%. Standard deviation is way for us to measure the historical returns of a portfolio and measure how much volatility there was in its returns. This is where that disclosure you see on every investment industry document comes in: PAST PERFORMANCE IS NOT AN INDICATOR OF FUTURE RESULTS. Just because a portfolio had a standard deviation of 10.8%, it doesn't mean that's what it will have that sort of volatility in the future. (It would be interesting to look at what the standard deviation would be prior to 2008-2011 for this model. Maybe in a future blog post.)Now look at the illustration on the right. It has further diversification including some more aggressive investments like emerging market stocks and exposure to commodities (although I'm not sure exactly what or how as the chart doesn't specify which index is being used.) The result is that the return is slightly better than the first illustration, but with less standard deviation of returns. The lower standard deviation of the second portfolio is important. It tells us that the second portfolio had slightly better returns with less volatility or risk. Why was the standard deviation less? If you look at the bar chart at the bottom of the graphic, you can see the returns of the individual asset classes that make up the hypothetical illustrations.Several of the asset classes added in the second portfolio had better returns than the components of the first illustration. Not shown is the correlation or how the asset classes made their returns. From experience, I know these investments don't all move in step with one another. It's this variability of how they performed that, when blended together in a portfolio, creates lower volatility. We can also see that over the time period covered by the graph, real estate was the top performing asset class. It is very important to remember that just because real estate was the highest performer in this illustration, doesn't mean real estate will be the best investment over the next 10 or 20 years. And that's the point of diversification: no one knows what asset class will be the top performer next year or for the years after that.What we do know is that by properly diversifying, investors have been able to lower their overall portfolio risk as measured by standard deviation, while still receiving good overall returns. Which brings me to the pro-advisor part of this post. Individual investors can absolutely manage their own finances and save the cost of using an advisor. All it takes is time and knowledge. However, if you look the last item on the bar chart above, you can see that historically individual investors haven't been able to manage their returns as well as they should have. I'm not sure how the creator of the above graphic arrived at that return, but I do believe that it is probably not far off for some investors.How is this underperformance explained? I believe that many times it is because of the emotion in managing money. After doing this for 10 years and working through the great recession, I've seen first hand the stress investors feel from having their portfolios go down. It's not fun but it's part of being an investor. I've been following with great interest the many recent launches of online solutions that allow an investor to manage their portfolios themselves through quantitative models that allocate your investments based on a risk tolerance model. These programs offer lower costs than a traditional advisor plus the benefit of a set program to manage your money. In theory this would also reduce the emotional quotient of the investment process, assuming the investor sticks with the program! So these are two of my keys to effective asset management for individual investors: diversification and emotional control.