The power of diversification

🥇 Can a diversified portfolio beat the market?

Source: Portfolio Visualizer Asset Class Backtesting tool. Past performance is not a guarantee or indication of future returns.¹

Investors often believe that diversification is a drag on wealth. The bull market of the past 15 years has resulted in many investors questioning the value of diversification — while chasing performance.

Who wants 4% return from bonds, when the S&P is returning 20%?

However, not diversifying is a mistake - one that history has shown to be very costly.

Read on to see how a properly diversified portfolio can not only protect your wealth, but also outperform the market over the long-term.

 🚧 Constructing a simple diversified portfolio

For this example, we constructed a simple diversified portfolio made of three asset classes:

• Stocks.

• Bonds

• Gold

We chose these asset classes based on the sound financial theory of Harry Browne’s permanent portfolio (covered in one of our previous issues).

Harry believed that different asset classes do well during different economic cycles.

• Stocks do well during periods of growth

• Bonds do well during periods of deflation

• Gold does well during high inflation. It has also been a safe haven during crises. (We have explored the advantages of Gold previously)

Next, we assume a growth oriented investing mindset and a long-term horizon (10+ years). With those assumptions, we allocate our portfolio as follows:

• 50% to higher risk and higher growth assets i.e. stocks

• 25% to lower risk and lower growth assets i.e. bonds

• 25% to a safety asset i.e. gold

Now that the asset class allocation is fixed, we choose our assets

Stock Selection

For stocks, we diversify globally, but tilt in favor of the US. Within the stocks bucket, we allocate:

• 60% to US stocks (i.e. 30% of portfolio)

• 40% to International stocks (i.e. 20% of portfolio)

For US stocks, we choose the Vanguard Total US Market Index Fund, which provides exposure to the entire US equity market (Large cap, mid cap, small cap). With 3555 stocks, it is way more diversified than the S&P 500 (just 500 US stocks)

For internationals stocks, we use Vanguard Total International Stock Index fund that provides broad exposure to stocks in developed and emerging markets, outside of the US. With 8564 stocks, it is heavily diversified.

Bond Selection

For bonds, we choose to invest globally as well — and not be limited to US.

We use PIMCO Global Bond Opportunities Fund (US Hedged), which provides comprehensive exposure to global fixed income markets with limited currency risk.

Here is our simple diversified portfolio

📆 Picking the evaluation period

We chose to evaluate this portfolio across two decades from 2000 - 2020.

Why?

2000 - 2009: This was the ‘Lost Decade’ for US stocks, with poor US stock market performance

2010 - 2020: This was the bull market that emerged from the recessions, with strong US stock market performance

By comparing the performance of this simple diversified portfolio across long bust and boom cycles, we can see how investors might have fared in each of them.

Note: We rebalance the portfolio annually, to maintain our target allocations.

2000 - 2009 Performance

Source: Portfolio Visualizer Asset Class Backtesting tool. Past performance is not a guarantee or indication of future returns.³

The simple diversified portfolio returned 6.16% annualized. It was able to grow wealth during a period of significant economic certainty. With lower volatility.

The S&P 500 meanwhile lost money during this decade. During the depths of the recession, it had lost more than 50% of its value.

2010 - 2020 Performance

Source: Portfolio Visualizer Asset Class Backtesting tool. Past performance is not a guarantee or indication of future returns.¹

The next 11 years were boom years, fueled by ZIRP (zero interest rates). Stocks did really well. The S&P 500 handily outperformed the simple diversified portfolio.

However, the simple diversified portfolio still provided superior protection during temporary pullbacks (drawdowns). And much lower volatility.

📈 Overall Performance

Source: Portfolio Visualizer Asset Class Backtesting tool. Past performance is not a guarantee or indication of future returns.¹

When viewed over a 20 year horizon, across boom and bust cycles, the simple diversified portfolio was a clear winner.

Even though S&P 500 outperformed the simple diversified portfolio over 11 years from 2010-2020, it could not overcome the gap created over the ‘Lost Decade’.

Not only did you come out ahead with the diversified portfolio, your journey was far more pleasant. No decade of suffering. No near-death experience.

💡 What’s the lesson?

When looking at long-term outcomes, it is clear that diversification is more than a mere defensive strategy.

When executed properly, it allows investors to participate significantly in the gains, and provides reasonable buffer from losses.

Professionals will tell you that in investing, higher risk has to be taken to generate higher returns.

The simple diversified portfolio only had 50% invested in higher risk assets (i.e stocks). Yet it outperformed the S&P 500, which has twice the risk (100% in stocks).

And remember, to get the 6.5% S&P 500 return over these 20 years, you would need the intestinal fortitude to sit through a -50% drawdown and 10 years of -1% annualized return.

Would you have been able to do sit through the pain?

Or is it likely that you would have sold in panic, and therefore realized a much lower return?

🤔 Why does the simple diversified portfolio work?

Three reasons:

1. It’s based on sound economic and financial theory 

   It acknowledges that markets and economies move in long cycles. It doesn’t try to predict which cycle is coming next. It just assumes that those cycles will arrive. By having a mix of growth and safety assets in the portfolio, it allows you to benefit in each of those cycles.

2. It diversifies risk thoughtfully - no eggs in a single basket

   The S&P 500 is limited to the largest 500 US companies. The world is much bigger than that. By spreading risk across thousands of stocks, it ensures that no single stock can tank the portfolio. It also allows you to generate gains from other US sectors or international markets that may do well. Growth doesn’t happen in just one sector of the US stock market.

3. Lower Volatility

   The simple diversified portfolio had 40% less volatility than the S&P 500. Volatility is the silent killer of returns. All else being equal, lower volatility portfolios outperform higher volatility ones. We covered this topic extensively in our previous issue.

🤷 Why doesn’t everyone do this?

Because it’s hard.

It’s hard to be content with 7% returns, when your neighbor who’s investing in the S&P 500 is getting 14% during boom times.

FOMO is real.

As humans, we are naturally optimistic. And have strong recency bias.

Sticking to a diversified portfolio requires patience and discipline - especially during roaring bull markets, when everyone around you seems to be getting rich.

But as a reward, you get to keep your wealth - and even grow it - when everyone else is losing their shirt!