Reducing Volatility through Diversification

Diversify, diversify, diversify.  That’s been the golden rule of investing for decades.  Conventional wisdom has argued for years that investors need to spread their investments across a variety of asset classes and investment types in order to reduce their risk.  I’m happy to go on record as saying that I wholeheartedly agree.

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While concentrating an investment portfolio into only a few investments certainly gives an investor the best chance to hit it big in the stock market, it also creates to greatest opportunity to lose it all (think Enron).

I find that most investors who are simply trying to save for retirement are willing to sacrifice the “homeruns” for a little more consistency and predictability.  And that’s what can be accomplished through diversification.

Will it guarantee that you’ll never lose money in the stock market?

Certainly not, but it helps to smooth the ride a little.

Let’s take a look at an example.

First, it’s important to understand that investment risk is often measured by how volatile an investment is.  In other words, how much does the investment earn in good years and how much does it lose in bad ones.

Using the chart below (click image to zoom), the green boxes represent the returns for emerging market investments over the 22 year period ending in 2013 (2014 figures are still being compiled and will be available soon).  These are essentially highly-volatile investments held in still-developing countries.

Major Asset Class Returns Chart

Notice that there have been four years in which these investments have earned a greater than 50% return.  That’s pretty amazing by most investor’s standards.

But don’t get too excited, because there’s bad news as well.  Notice that these same investments had negative returns in ten of the 22 years represented in the chart, including a 53.18% loss in 2008.  That’s pretty hard for even the bravest investors to swallow.

By contrast, take a look at the purple boxes, which represent the overall U.S. bond market.  These investments have a tendency to produce the lowest returns out of the group.  In fact, they came in last place nine times, while only coming in first twice.  The tradeoff, however, is that these investments only produced negative returns three times, and never lost more than 3% in a given year.  That’s pretty reliable.

So how does an investor get the big returns of the emerging markets with the consistency of the bond market?  Well, unfortunately they don’t.  There is a consistent trade-off between how big an investment’s returns are and how volatile it is.  The good news, however, is that a diversified portfolio helps you achieve nice returns with reduced volatility.

Take the white boxes for example.  This is a hypothetical portfolio that’s been diversified using portions of the other investments in the chart.  It consists of:

  • 20% U.S. Large (grey boxes)
  • 13% U.S. Small (orange boxes)
  • 22% Foreign (blue boxes)
  • 15% Emerging Markets (green boxes)
  • 10% U.S. Real Estate (maroon boxes)
  • 20% U.S. Bonds (purple boxes)

You should notice that this portfolio is never the highest producer of the group, but never the lowest producer either.  In good years, the high flying investments help provide it with adequate returns, while in bad years the low volatility investments make sure it doesn’t plummet too hard.

Compared to the S&P 500, represented by the grey boxes, the diversified portfolio averaged very similar results over the 22 year period, 9.18% for the S&P 500 vs. 8.95% for the diversified portfolio, yet it was much less volatile.  And what about those amazing emerging market funds that produced 50% or more returns?  The diversified portfolio actually outperformed it over the 22 year period by over ½ percent per year.

Remember, diversification won’t always increase your overall returns, but it’s almost guaranteed to reduce volatility in your portfolio and help to provide a better overall investor experience.

If the diversification of your investment portfolio needs to be reviewed, call us today.

Free initial consultations can be requested by calling 512-383-8353.

2017-08-22T13:56:10+00:00

About the Author:

Tim Plachta, CFP® owns and operates Reliant Wealth Management and Reliant Consulting Partners.  He works primarily with small business owners to help them increase profit, reduce their workload (so they can relax more), and invest enough of their earnings to achieve financial independence.