Diversification

During 2008 and 2009, some claimed that diversification of stock investments is no longer beneficial, and, consequently, that we should look elsewhere to reduce our investment risks. This article assesses these claims, and demonstrates, through analysis, the benefits of diversification, even in the face of the 2008 decline. More specifically, it will discuss the potential benefit of adding small, international and emerging markets stocks, to help diversify the typical US centric portfolio.

What seemed wrong with Stock Diversification in 2008? During the market decline of 2008 all stock classes declined substantially. Adding small, international and emerging markets stocks, not only did not help a U.S. centric portfolio, but even aggravated the decline, leading to a lower bottom. This can be seen in the graph below, comparing the globally diversified portfolio Long-Term Component with the S&P 500 in 2008-2009.

This result may lead you to believe that stock diversification failed.

If you redeemed your entire investment after these two years, stock diversification would not have helped you. However, a two-year investment should not be put into any stock portfolio.

Appropriate usages of stock investments include:

1. Long-Term Growth
2. Immediate retirement income, as long as withdrawals are limited to a small percentage every year¹.

Contrary to Some Claims, Global Diversification of Stocks was Successful . If we expand the period of comparison by two additional years, starting in 2006, we get improved results, thanks to higher returns surrounding the decline. Diversification provided substantially improved security, flipping the total returns to positive, with a total difference of 24%.

If we further expand the comparison to the 10 years 2001-2010, we get a striking difference greater than 200%.

While the correlation between the portfolios seems relatively high, the diversified portfolio provided substantially better results. Two factors helped, as can be seen in the graph above:

1. In early 2002 there were several months in which the diversified portfolio gained, while S&P 500 declined. These few months were enough to have the diversified portfolio recover from the early 2000’s recession very quickly and have a lasting impact until today.
2. In 2003-2007 the diversified portfolio had faster overall growth, providing a result 3 times larger (200% higher) than the S&P 500. So, while the S&P 500 stayed at levels below the level of 10 years ago for a long period, the diversified portfolio maintained nice gains throughout the entire 2008 decline.

To judge whether diversification is beneficial, we should do two things:

1. Compare the length of declines, in addition to the depth. In the middle graph (4 years), you can see that, thanks to the higher 2009 returns, the recovery above the 2006 level occurred many months earlier.
2. Expect diversification to provide some moderation or shortening of declines, but not eliminate severe declines altogether. Given that diversifying a U.S. Large centric stock portfolio does not hurt the long-term returns (it actually increases them), it would make sense to diversify even without any risk-reduction benefit. Not only is there a risk reduction benefit, it occurs in most declines and tends to be substantial.

To further demonstrate the benefits of stock diversification, a table is provided, comparing the diversified stock portfolio to the S&P 500 over different horizons, all relevant for a retiree looking for current income:

Annual Returns: S&P 500 vs. Diversified Stock Portfolio (Long-Term Component)
Calendar	Years	S&P 500	Long-Term Component	Annual Benefit
2007-2009	3	-5.6%	-2.2%	+3.4%
2005-2009	5	0.4%	7.7%	+7.3%
2001-2010	10	1.4%	14.3%	+12.4%

Summary

Despite claims to the contrary, stock diversification still holds, and is beneficial through declines, including the great 2008 decline. Diversification may help shorten tough declines and/or make them shallower. In some cases, the benefit appears before and/or after the decline, still providing a great benefit to the long-term investor as well as the retiree that depends on current income.

¹ 3%-4% is a common range, depending on the portfolio

Disclosures Including Backtested Performance Data

[Updated Data February, 2011]

This article provides important guidance for conservative investors. It is especially important for retirees with limited or no sources of new income.

It is a common belief that as a conservative investor, you should put your money in some of the most stable companies in the world: the largest stocks in the US . Many people go one step further, diversify and hold 500 of these through an S&P 500 Index fund, in order to reduce the risks specific to any particular company. In addition, some hold onto them for the long run, and avoid the big risk of buying or selling at the wrong time.

Is this a conservative approach?

This approach reduces many of the risks investors face today, but you can do much better! You probably heard that if you can afford to take higher risks you may benefit from higher returns by holding stocks of small and international companies. These companies are indeed riskier than the companies in the S&P 500, but if you hold them together in one portfolio, you may reduce your total risks.

Can this work in real life?

Yes, the Long-Term Component by QAM is an example of a portfolio that holds thousands of companies, some very risky when observed individually, and is significantly more conservative than the S&P 500.

Let’s look at the 2000-2002 recession and recovery periods for the S&P 500 and Long-Term Component.

The following table summarizes certain differences between the portfolios:

	S&P 500	Long-Term Component
Recession max decline	-45%	-20%
20% decline duration	39 months	1 month
Recession to recovery period	6 years 1 month	2 years 4 months
Returns from bottom to 12/2007	98%	321%

All measures are striking and especially notable is the recession to recovery period. It took 6 years for the S&P 500 to recover, compared to 2 years for the diversified portfolio.

Why does this work?

The change in value of a portfolio is a result of the combined changes of its components. During the recession period, many companies in both portfolios declined significantly. Some went bankrupt. The key to the Long-Term Component’s success was lower correlation between the prices of the stocks in it.

All companies in the S&P 500 are subject to the same risks common to large companies in the US . The decline in the US affected 100% of the portfolio. The long-Term Component is diversified in nearly 40 countries around the world, including large and small companies. Small companies tend to better diversify since they serve more local markets and are less affected by global events.

Even small differences in the timing of recessions around the world, reduces the duration and magnitude of declines in the portfolio. The following example demonstrates this principle:

Imagine two portfolios that each had the same returns with a 1 year offset between the two, a 2 year recession and a total decline of -14%. The following table shows the portfolio returns each year.

Year	1	2	3	4
Portfolio 1	12%	-10%	-4%	6%
Portfolio 2	-10%	-4%	6%	12%
Combined (equally)	1%	-7%	1%	9%

When the portfolios were combined they had half the decline (7%) for half the duration (1 year), compared to the declines of each of the individual portfolios. This demonstrates how two portfolios with the same risk characteristics, but some difference in the timing of recessions, had much shorter and shallower declines, when combined together.

Reduce risk or increase returns?

Both! As demonstrated above, diversification can result in higher returns despite the lower risk. These high returns are a very nice benefit, but remember that the first priority of a conservative investor should be to limit the risk to acceptable levels. Only within these constraints you should try to maximize your returns. Diversification should be practiced even if the returns where not higher. The higher returns are a benefit of the diversification, not a reason for it.

To Summarize

Constructing a diversified portfolio that limits the risks to an acceptable level are a must for every investor, and especially for people with limited current income.

Any portfolio considered should be judged as a whole and without letting emotions get in the way. Risky stocks, having low correlation with an existing portfolio, make the portfolio more conservative, while low-risk stocks having high correlation with the portfolio do not reduce the risks.

To stay most conservative, you should include thousands of companies and avoid individual stock selection or market timing altogether (e.g. using index funds).

Disclosures Including Backtested Performance Data

US Stock funds with diversified positions lost 2.76% percent in the third quarter, based on preliminary figures from fund-research firm Lipper.

A portfolio of globally diversified stock funds (Long-Term Component by Quality Asset Management – QAM) achieved positive returns of 3.58%. If you are thinking that sophisticated prediction of the quarter was involved, you are giving too much credit to Dimensional Fund Advisors (the mutual fund company) or QAM. These are mutual funds that hold over 6,000 companies throughout the world, representing the different asset classes. Similar to index funds, they include all stocks that fall into set criteria that define the asset class, with no preference to one over the other.

What is the secret, then? Simple global diversification. As you can see in the chart below, different asset classes went up at different times. Specifically, emerging markets showed high returns, while international stocks went slightly higher, all which offset the negative performance of US stocks for the quarter.

Disclosures Including Backtested Performance Data