The Investment Scientist

Why Asset Class Diversification is Superior

Posted on: July 6, 2011

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.

20 Year Asset Class Returns

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
Momentum (MS) 3.88% 20.85% $135k
Contrarian (CS) 10.91% 21.32% $538k
Diversification (DS) 9.66% 12.61% $551k

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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4 Responses to "Why Asset Class Diversification is Superior"

The BlackRock table is one of my favorites. It nicely illustrates how diversification reduces volatility.

Are there any tables similar to this?

I was at a seminar recently by Urs Meisterhans of Sinitus where he had a similar table which I thought was immensely helpful.

I’ve been looking for it but to no avail. Do you have anything similar to this?

Yes, Dimensional Fund Advisors has a similar table.

[…] one of my previous posts, I showed how diversification across asset classes is superior to momentum and contrarian strategies. Today, I am going to show how disciplined […]

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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