Q: I am frustrated. I was told to diversify my holdings using index funds, so I did. I was told to put part of my investments in foreign stocks, so I did that too. Now I find that my portfolio isn’t keeping up with the market. If diversification is such a great idea, why does it hurt so much?
A: If you diversified your portfolio hoping it would boost your investment performance, I can understand why you might be frustrated. Though it can sometimes help with performance, diversification is mostly an exercise in risk management.
Diversification has been a well-known risk management idea for years and not just with respect to investments. Remember the old saying about not putting all your eggs in one basket? Portfolio diversification works the same way. By spreading the risk, we protect ourselves and our wealth from the uncertainties of the market.
Although diversification has the benefit of lowering portfolio risk, it can also carry a cost. For example, since 2012, the S&P 500 stock market index has produced an annual return of 14.86 percent. A well-diversified portfolio, on the other hand, returned just over 8 percent. Based on these numbers, we could argue that diversification cost 6.46 percent per year. Perhaps that’s why you say diversification hurts.
However, if we compare the returns on the S&P 500 and a diversified portfolio over other time intervals, our judgment might be very different. For example, between 2002 and 2007, the S&P 500 gained 6.55 percent per year while the diversified portfolio returned 10.99 percent. In this case, diversification actually added 4.44 percent to annual performance. And if we look at the entire interval from 2002 to the present, the S&P 500 is up 6.7 percent on an annualized basis while the diversified portfolio is up 6.9 percent.
Perhaps a better way to think about the cost of diversification is to consider it as the cost of uncertainty. If you knew with certainty how a particular asset class was going to perform, there would be no need to diversify your portfolio. Since we can’t know with certainty, diversification is the best option.
Q: When I diversify my portfolio, how do I decide how much to place in different investments?
A: Several years ago, Harry Markowitz published an essay that tried to answer this question. His approach, known as Modern Portfolio Theory or MPT, changed the world of finance and eventually won Markowitz the Nobel Prize in economics.
MPT is a theory by which investors can diversify portfolios to get the highest expected return for a given level of portfolio risk. Risk is defined as portfolio variance or the degree to which a portfolio’s actual value fluctuates around its expected value. The greater the variance, the greater the risk. If you want more details on Modern Portfolio Theory, I recommend the entry on Investopedia.com.
There are a few good online tools that can help you understand how well your current portfolio is diversified. Many of these tools are anchored in Modern Portfolio Theory. A quick and easy tool is at https://www.portfoliovisualizer.com/efficient-frontier. Simply enter your portfolio’s asset allocation and the minimum and maximum percentages you would allow in each asset class. The app will plot the risk and expected return of your current portfolio and suggest an alternate allocation for same level of risk.
Steven C. MerrellMBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to firstname.lastname@example.org.