In a previous article, we discussed the idea that a properly diversified portfolio provides investors with an effective tool for reducing risk and volatility, without necessarily giving up a return. Below is an example of how diversification across asset classes really works.
Let’s compare two blended index portfolios for the 20 year period ending December 31, 2013.
As you can see, both portfolios produced almost exactly the same return.
However, if we look at the volatility of the two portfolios (as measured by standard deviation), the second portfolio produced that same return with less volatility.
It also experienced a much lower “lowest one-year calendar return”, which happens to be 2008 for both portfolios. In 2008, the first portfolio produced a return of negative 32%, while the second produced a return of negative 23%.
So how did this happen? By accident or due to portfolio design? We would argue it’s the latter.
While both portfolios are diversified in terms of owning a large number of holdings, only the second portfolio provides “real” diversification by combining asset classes that behave differently.
Portfolio 1 combines two asset classes that are both dependent on the fortunes of large US companies. As a result, they are highly correlated. For example, in 2008, the year of the financial crisis, the S&P 500 was down 37%, while the high yield corporate bond index was down 26%.
Portfolio 2 also includes S&P 500 stocks, but then also incorporates high risk/high return small-cap value stocks AND relatively low-risk intermediate government bonds. Small cap value stocks boost the return of the portfolio, while the government bonds reduce the volatility. For example, in 2008, while stocks were crashing, intermediate government bonds produced a positive return of more than 10%. Even during the worst financial crisis in 80 years, diversification worked.