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  • Diversification in Pictures 1 comment
    Oct 21, 2010 4:00 PM

    If a picture is worth a thousand words, when it comes to the payoff of diversification, a chart or two may prove even more valuable.

    The principles over at MyPlanIQ, a firm specializing in sorting through corporate 401k plans and offering suitable portfolios from the funds on offer, have put several together. They show what portfolio theory teaches: that adding more asset classes to a portfolio improves its performance over time.

    Here is a comparison of the performance of portfolios of increasing diversity from 2009 to the present. (Click chart to enlarge):

    In the graphic above, the lowest orange line is a portfolio consisting of three index funds tracking different asset classes : 40% in Fixed Income, 30% in US Stock, 30% in International Stock.

    Green is slightly better with four funds: 40% Fixed Income, 20% US Stock, 20% International Stock, 20% REIT.

    Gray is better still, with five funds: 40% Fixed Income, 15% US Stock, 15% International Stock, 15% REIT, 15% Emerging Markets Stock.

    Blue is tops with six funds: 40% Fixed Income, 12% US Stock, 12% International Stock, 12% REIT, 12% Emerging Markets Stock and 12% Commodities.

    As the graph shows, the more assets, the better the returns.

    In the short term, as the diversification and returns rise, investors seem to be better compensated for their investment risk. Over one year, the Sharpe Ratio ranges from 83% in the portfolio of 3 asset classes, up to 105% for the portfolio of six. Higher is better.

    Over a longer stretch, the risk-adjusted returns of all portfolios comes down. Looking back to 2001, the four-sector portfolio, for example, has an annualized return of 6.62% and a Sharp Ratio of  40.29%.

    The very best performance over the ten-year period comes from the five-asset portfolio, with a 7.71% average annual return and a Sharpe Ratio of 44.93%. The six-sector portfolio has a slightly lower 7.61% annualized return but a better 49.7% Sharpe Ratio.

    Which seems to imply that diversifying pays, but there may be a diminishing return at some point.

    Here is a chart of the same group over the longer time horizon, stretching back to 2001. (Click chart to enlarge.):

    Disclosure: No positions
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  • Brad Case
    , contributor
    Comments (277) | Send Message
    Good post, Nanette. Yes, there is a bunch of research from academic finance specialists showing that the benefit from diversification is very strong, but diminishes as the number of asset classes increases.
    There are four fundamental asset classes that should be in every portfolio: cash (for immediate needs), bonds (for income and low returns with low risk), stocks (for high returns), and real estate accessed through publicly traded REITs (also for high returns but with a low correlation to stocks). Domestic and international are less important than having access to those four asset classes. Cash doesn't show up in the investment portfolio allocations because it's just the portion that's not invested.
    The green portfolio is the first that has all three fundamental asset classes, which is why it's so much better than the orange portfolio. Grey and blue are only very slightly better, because they add a piece of an already existing asset class (emerging stocks) and a non-essential asset class (commodities).
    23 Oct 2010, 10:49 AM Reply Like
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