The 10-second version: The goal of diversification is to maximize your return for the risk you are taking on. Many people only diversify between stocks and bonds, however, this could result in a less diversified portfolio than you’d expect. Stocks and bonds are positively correlated and perform poorly during inflationary recessions (the 1970s and 1980s) and because the volatility of stocks is so much higher than that of bonds, most portfolios are too exposed to the returns of their stocks. You should consider adding real estate, commodities, and inflation-protected securities to your portfolio to account for this.
Okay, let’s dive in.
Hello finance aficionados (my word of the week),
Today we are going to dive into why your portfolio might be less diversified than you’d think.
Let’s start with the point of diversification – to minimize the volatility of your portfolio to changes in economic conditions while maintaining an optimal return. That’s meaty. Let’s break it down:
- Minimizing volatility – you don’t want your portfolio to swing by 30% every other day. That would make it fairly difficult to ensure that you could withdraw money at any time and it would also be quite terrifying on bad days
- Maintaining an optimal return – you don’t want to put all of your money in a safe, but extremely low returning asset because you want your money to grow over time
Finance nerd tangent – In finance, there is a ratio called a Sharpe ratio that is used to evaluate the performance of an asset relative to its volatility. If you are a fan of math..or let’s be real..you at least don’t hate it, the formula is:
Where the risk-free rate can be approximated by the returns of a US treasury bill.
Anyways, the higher this ratio, the better your risk-adjusted return. For most assets (i.e. stocks, bonds, etc.) you see a Sharpe ratio of ~0.3 over time (i.e., you get 0.3 “units” of return for every equivalent “unit” of risk).
Sound small? A Sharpe ratio of 0.3 on the S&P 500’s standard deviation of 16.5% for the last ~40 years corresponds to a +5.5% annual return on top of the risk-free rate. The S&P has actually had a higher average Sharpe ratio over that period of time – but let’s not worry about that for now.
Okay, let’s step back from the math.
The point of diversification is to increase that return for a given level of risk, and when done properly you can generate strong returns without seeing as much volatility in your portfolio – probably a good idea, yeah?
So what constitutes diversification and what will drive down that standard deviation?
First, within a type of asset (i.e. stocks, bonds): invest in indexes rather than individual companies. Read why in my post How I Invest for an explanation.
Second, across assets: Invest in assets that are diversified to changes in economic conditions. A lot of people would tell you to invest in assets that are uncorrelated to each other, but that would be fairly deceptive as the correlation of assets to one another changes depending on the underlying economic conditions.
A prime example here is the return of stocks and bonds (everyone with a 60/40 portfolio this is your time to tune in). First, let’s take a high-level look at stock and bond excess returns from 1980-Present. Excess returns just mean they are adjusted for inflation:
The red boxed years are times when stocks and bonds both performed poorly. That is, they had the same reaction to negative changes in economic conditions. That’s exactly what you don’t want.
There are 2 reasons that bonds might not offset off-years for stocks:
- Stocks and bonds are sometimes positively correlated (i.e., the underlying economics of stocks and bonds yields the same behavior). For example, when inflation expectations change, both stocks and bonds perform similarly (check out an article from Warren Buffet on this). A perfect example is 1981 when an Iranian oil embargo caused oil prices to spike and set off a major recession. Input prices for companies and individuals increased, which hurt stocks by reducing profit margins, and the value of bond prices plummeted as the present value of their future cash flows nosedived.
- Stocks are (on average) more volatile than bonds. The standard deviation of S&P excess returns for the last ~40 years has been ~16.5% while the standard deviation of bonds has been only ~6%. With a 60/40 split portfolio that means that ~80% of your returns will be determined by how your stocks are doing, so even if bonds go up when your stocks go down, the performance of your portfolio as a whole would look a whole lot more like the performance of your stock holdings.
Here is an article on how to actually diversify your portfolio given the above changes written by hedge fund Bridgewater Associates.
My biggest piece of advice to deal with this is to make sure that you include some assets in your portfolio that will do well during inflationary periods – real estate, oil, inflation-protected securities.
Until then, invest smart, not hard!
Readwritemoney
