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Diversification vs Asset Allocation—Which Makes a Better Cake?

Diversification vs Asset Allocation—Which Makes a Better Cake?

Ron Kelemen - Wednesday, June 29, 2016

Our clients know that we are big proponents of diversification, which basically means spreading your eggs into different baskets to reduce risk in an ever-changing investment world.  Since 1970, a portfolio of 10 equally divided asset classes would have had an average return of 9.82%. 

In a rising market where one particular asset class does extremely well, a diversified portfolio will lag because not everything in it is going up as fast and some things may be going down.  This was especially true in 2015 when a portfolio of 10 equally divided asset classes declined -4.3%, yet the S&P 500 had a modest gain of 1.2%, including dividends.  This was the worst decline since 1974, except for 2008.  Then, however, the decline of a diversified portfolio was (only) -20.35%, far less than the S&P’s decline of -36.55%.

(Source:   Morningstar.  Asset classes represent equal weightings of the following 10 indexes:  Ibbotson 30-Day T-Bill (Cash), Barclays US Government (US Government Bonds) , Barclays US Credit (US Corporate Bonds), Barclays US Corporate High Yield (High Yield Bonds), Citi WGBI Non-USD (Foreign Bonds), S&P 500 (US Large Cap Stocks), Russell 2000 (US Small Cap Stocks), MSCI EAFE (Foreign Stocks), FTSE/NAREIT Equity REIT (US REITs), S&P GSCI (Commodities).  If a particular index did not have a sufficient track record back to 1970, a representative index of similar risk/reward characteristics was used.)

Diversification is often confused with asset allocation, which is a type of diversification.  Asset allocation places more emphasis on the mixture of assets rather than whether to own Stock Fund A or Bond Fund B.  Using mathematical models, it attempts to pair assets that zig when the other zags.  Many asset-allocated portfolios (including ours) didn’t decline as much as an equally diversified portfolio would have in 2008 and 2015 because of the attention paid to the mix of asset classes. 

Think of baking a cake.  If you added equal amounts of flour, sugar, water, vanilla extract, cocoa powder, eggs, and baking powder, you’d have a huge mess in your oven.  A good cake recipe is a careful weighting of ingredients.  When we use the term “diversified,” we really mean a carefully constructed portfolio using asset allocation principles.

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