Diversification is standard practice in portfolio management. Owning investments in several different asset classes helps reduce the risk of a large loss and increases performance in the long-term. Advisers often call the process the only “free lunch” on Wall Street. Most investors do it, from individuals to large institutions. Some people do it better than others.
This two-part series examines asset allocation basics. Part 1 includes the screening process I use for deciding whether an asset class fits a portfolio. Part 2 examines how I use correlation analysis during the selection process. These topics are discussed in more detail in All About Asset Allocation.
A well-diversified portfolio holds investments from multiple asset classes. The benefit from this strategy is two-fold. First, portfolio risk is lowered, and second, performance is enhanced over time.
In a multi-asset class portfolio, there’s an increased probability that at least one investment will flourish while everything else is going down the toilet. Treasury bonds provided the perfect example in 2008. They scored their biggest gains in a decade while stocks and commodities plummeted. The inclusion of U.S. Treasuries in a portfolio reduced the loss and lowered volatility. In addition, an extra benefit was earned by investors who practiced a buy, hold and rebalance strategy. Selling bonds to buy stocks during the 2008 market collapse provided an extra return during the rebound in 2009.
Asset class selection plays an all important role in whether you earn benefits from diversification. Wall Street markets every asset class as the answer to an investor’s prayers, so it’s important to have a sound selection process. I use four gates when selecting asset classes. The four gates in order of priority are:
- Fundamentally different – asset classes must be fundamentally different and have unique risk. Stocks and bonds are different; one is ownership and the other is loan. U.S. stocks are different from international stocks in base currency and government policy. Real estate and commodities differ from common stocks in collateral structure. In contrast, U.S. mid-cap stocks are not fundamentally different than large cap and there is very little unique risk. I’ll show how correlation analysis is used to measure unique risk in Part 2.
- Real return – an asset class must generate a real return in the long-term (after-inflation). U.S. stocks have outperformed inflation by about six percent historically and real estate has earned about the same. Government bonds have outperformed by about two percent. In contrast, commodities have no expected return over the inflation rate and do not pass this gate.
- High liquidity – an asset class must have daily liquidity. Stocks that trade on an organized exchange, and bonds that trade over-the-counter on a regular basis, pass this gate. Real estate ownership − outright or in a partnership − would not pass this gate, although real estate investment trusts (REITs) are exchange traded and do pass. Coins, artwork and other collectables tend to be illiquid and do not qualify.
- Diversified, low-cost funds – the asset class must be packaged in a liquid, low-cost and broadly diversified product such as a mutual fund or exchange-traded fund (ETF). Since all the analysis on has been based on an index, I prefer to replicate that index in portfolios with index funds and ETFs. An actively-managed product can be used (absent of a good index product), as long as it is broadly diversified and low cost. An example would be the Vanguard Intermediate-Term Tax-Exempt Fund Admiral Shares (VWIUX).
Most years go by without a large risk reduction benefit from diversification or excess return benefit from rebalancing. But this doesn’t mean you shouldn’t do it. It’s the long-term total return that matters.
The four gates selection process held up well over the volatile decade from 2000-2009. U.S. stocks had a negative total return, while a diversified asset class portfolio based on the four gates had positive total return in excess of the inflation rate.
In my next blog, I’ll discuss how to use correlation analysis in asset class selection.