Stock Market Diversification Works! The Proof

To make money in the stock market, all you need is a proper asset allocation and time.

If you’re nervous about the stock market recently, you’re not alone. Your anxieties over your investments may be attributed to several reasons.

Could you be overexposed to the stock market?

Is your portfolio too concentrated in just a few asset classes?

Have you been investing for only a short period of time?

If you agreed with any of these points, then your concerns may be justified. But fear not! By reviewing past stock market performance and by appreciating the evidence put forth by long-standing investment principles, we should be able to develop portfolios that are less vulnerable to market swings and which can afford better returns over time.

I know some people who will never put their money in the stock market, arguing that “it’s just like gambling.” I get into some in depth debates with them about this, but to no avail — some people just equate stock market risk — or maybe any investment risk for that matter — to gambling risk, which is the worst kind of risk since the odds are set against you.

True, there is risk with participating in the stock market, but this is something you can easily control and manage when you take a few strategies into consideration. You won’t need a doctorate in economics to become convinced that these strategies work: the historical performance of market portfolios can speak for themselves. From my studies and experience, I discovered that I’d do well with the stock market if:

#1 My investments are well-diversified and have a reasonable asset allocation. (Diversification)

#2 My investments are subject to a long enough time horizon. (Time)



Let’s check out some numbers behind these statements made available to us by the Motley Fool.

How Diversification and Asset Allocation Affect Your Investment Returns

Over the last 35 years, here were the annual returns and standard deviations (among other measures) for 4 different asset classes: U.S. stocks, foreign stocks, REITs and Commodities. If you had placed all your funds in any one of these asset classes, it’s clear that you wouldn’t have done as well as you would have if you had instead divided your money into four equal parts and placed each 25% portion into each of the asset classes to create a mixed portfolio comprised of all 4 asset classes.

1972 – 2007 U.S. Stocks International Stocks Real Estate Investment Trusts Commodities Four-Asset Portfolio Return* 11.19% 11.75% 13.01% 11.65% 13.22% $1 turned into… $45.50 $54.53 $81.79 $52.81 $87.31 Standard deviation 17.02 21.66 17.37 24.52 11.00 Sharpe ratio 0.39 0.35 0.48 0.34 0.68 Worst 1-year return -26.45% -23.20% -21.42% -35.75% -12.77% Worst 3-year return* -14.56% -17.00% -10.49% -9.58% -0.56% Worst 5-year return* -2.31% -2.61% 3.29% -4.53% 3.34% Worst 10-year return* 5.91% 4.30% 9.14% 2.11% 8.74%

*Compound annual total return.

Source: Roger C. Gibson, Gibson Capital Management. Large caps from S&P 500; REITs from NAREIT Index; international from Europe, Australasia, and Far East Index; commodities from Goldman Sachs Commodity Index.

Through this example, we see that the use of asset allocation to produce a diversified portfolio has improved returns over time, as well as limited the portfolio’s downside. This 4 asset portfolio gives us:

A decrease in volatility (as evidenced by a lower standard deviation),

A higher risk-adjusted return (represented by the higher Sharpe ratio),

Much better returns across the board for the worst case scenarios (worst 1 year, 3 year, 5 year and 10 year returns).

You can see fairly similar results when you review this table, which swaps out commodities for U.S. small stocks in the asset class comparisons:

1972 – 2007 Large Cap U.S. Stocks International Stocks Real Estate Investment Trusts Small Cap U.S. Stocks Equal parts of 4 asset classes, occasionally rebalanced Annual Return 11.19% 11.7% 12.9% 14.3% 13.1% Standard deviation 17.02 21.66 17.4 22.5 15.7 Worst 1-year return (26.45%) (23.2%) (21.4%) (30.9%) (22.5%) Worst 3-year return (14.56%) (17.00%) (10.49%) (16.7%) (9.5%) Worst 5-year return (2.31%) (2.61%) 3.29% 0.6% 4.8%

We’re seeing similar conclusions here as those put forth in my previous article on foreign stock allocations as well as this article on the seven-asset portfolio (at Seeking Alpha), that concludes that you’ll get the best diversification benefits by incorporating asset classes that have low correlations to each other. Some highlights from the Seven-Asset Portfolio article by professor Craig Israelsen:

#1 Diversification works (surprise surprise)! When additional asset classes are added to a portfolio, you improve returns and limit the worst one-year drawdown of the total portfolio.

#2 The major changes to a portfolio occur when commodities and REITs are added to it because these asset classes have low correlations to core equity asset classes.

When people buy foreign stocks, they think they are diversified. But the three main equity asset classes have correlations of 0.7 to 0.9. You don’t get a lot of correlation benefit from adding more equities to an equity portfolio. Cash is a good diversifier, and so are bonds. But they don’t have a very attractive long-term return. The real benefit comes when you add REITs and commodities. They have equity-like returns, but low correlations … and in one important way, they have lower risk than equities.

#3 An investment portfolio can be improved by being a bit more exotic.

#4 Commodities aren’t as radical as you may think since they recover much more quickly than stocks, which tend to ride on trends and momentum for longer periods of time. This means that though commodities may generally have a higher standard deviation (overall volatility), they also tend to snap away from a losing streak faster than equities do, so their worst periods tend to be less significant than the worst case scenarios presented by equities.

At this time, our portfolio does not yet carry REITs nor commodities, but my research has convinced me to incorporate these types of investments in our portfolio. I’ve actually set the stage for this by writing out my recommendations in this post: Beat The Average Investor’s Returns With The Simplest Investment Portfolio, which I consider to be one of the most important investment posts I’ve written to date. I’ll be reorienting our current portfolio to improve on our allocations based on diversification concepts I’ve learned.

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