In order to achieve true diversification, and the critical advantage this provides - lower volatility - it is essential to diversify across asset classes. That is, your portfolio should at the very least hold some stocks and some bonds, and a material portion of your bond holdings should be high quality government bonds because these are the only assets whose diversification benefits increase when all other markets are in crisis.
To illustrate the misperception about stock diversification and emphasize the importance of asset class diversification, we created two portfolios out of 5 major markets and tested their performance back to 1995:
- The All-Stock Portfolio consisted of equal weightings in U.S. (SPY), EAFE (EFA) and emerging market (EEM) stock indices, rebalanced quarterly.
- The Asset Class Portfolio consisted of equal weightings in U.S. stocks (SPY), U.S. long Treasury bonds (TLT), and gold (GLD).
The chart below shows three important pieces of information:
- The actual daily realized volatility of each market. For example, the volatility of EEM over the period was 28.3% annualized.
- The average of the individual volatilities for the three markets in each portfolio. For example, the 'Average of Stocks' bar shows the average of the volatility for each of EEM, EFA and SPY: (28.3% + 22.1% + 20.9%)/3 = 23.8%. This approximates what the volatility would be if there were no diversification benefit of holding all three markets in a portfolio.
- The actual average observed volatility of each portfolio. This number captures the volatility after realizing the benefits of diversification. For example, the actual average observed volatility of the All-Stock Portfolio was 21.8%.
Markets that are held in the All-Stock Portfolio are underlined in red, while assets that are held in the Asset Class Portfolio are underlined in green. ETF symbols which track the markets are used in the chart rather than the full name of each market to save space (see symbol guide above).
Source: Butler|Philbrick|Gordillo & Associates. Data from Yahoo.
The average volatility of the individual stock market indices is 23.8%, but when we assemble them in a portfolio the portfolio volatility decreases slightly to 21.8%. The difference, 2%, represents the free lunch that results from the fact that the three stock indices do not move in perfect sync; that is, they are not perfectly correlated, so combining them produces a small diversification benefit. The percentage improvement to portfolio volatility - the diversification advantage - from combining international stock markets is about 8.4% [(21.8% - 23.8%)/23.8%], which is nice, but hardly comforting.
In contrast, while the average volatility of the individual asset class indices is lower at 16.5%, when we assemble them in a portfolio the portfolio volatility drops very substantially, to 9.1%. We can therefore infer that combining different asset classes in a portfolio produces a diversification advantage of almost 45%.
In other words, asset class diversification provides over 500% more diversification than diversifying across stock markets alone (45% vs. 8.4%).
Lest you assume that the Asset-Class Portfolio must have earned lower returns because of its much lower volatility, take a look at the following chart which adds annualized returns and maximum portfolio peak-to-trough drawdowns to our dataset. The Asset-Class Portfolio delivered over 50% better returns and less than half the drawdown of the All-Stock Portfolio over the time period considered.
Source: Butler|Philbrick|Gordillo & Associates. Data from Yahoo.
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