Why Asset Class Diversification is Superior
Posted July 6, 2011on:
Recently, I came across a 20 Year Periodic Return Table prepared by Black Rock. I want to share this with you since this table illustrates the investment principles I have been emphasizing: 1) asset class diversification; 2) disciplined rebalancing; and 3) small value tilt. Today’s focus is on 1); the other two points will be discussed in future articles.
To illustrate the point, I construct three stylized investment strategies based on the return table:
- Momentum strategy (MS) invests in the asset class that performed the best in the immediate past year.
- Contrarian strategy (CS) invests in the asset class the performed the worst in the immediate past year.
- Diversification strategy (DS) invests in the Black Rock standard diversification portfolio, which is made up of 35% aggregate bonds, 10% international stocks, 10%USsmall cap and 45%USlarge cap. (This is far from an optional balanced portfolio, but sufficient to make our point here.)
The average returns and volatilities of the three strategies are summed up in the table below
|Strategy||Average Return||Standard Deviation||Terminal Value of $100k invested|
It is obvious that MS is far and away the worst investment strategy, and yet this is probably the most popular strategy among amateur investors. The best performing asset class in the recent past caught their attention and imagination, and they bet their house on it.
CS and DS appear to deliver similar average returns and terminal values. Upon closer examination, however, DS achieved the same return with 40% less risk.
That is why, with my own money and my clients’ money, I never try to outsmart the market. I just hold an appropriately structured, well-diversified portfolio that includes all major asset classes.
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