How to diversify your investments

(MoneyWatch) This post is based on chapter 6 of Larry Swedroe's new book Think, Act, and Invest Like Warren Buffett. The data for today's post and the associated text have been updated through the end of 2012.

Because most investors have not studied financial economics and don't read financial economic journals or  books on modern portfolio theory, they don't have an understanding of how many stocks are needed to build a truly diversified portfolio. To effectively diversify the risks of just the asset class of U.S. large-cap stocks, you would have to hold a minimum of 50 stocks. For U.S. small-cap stocks, the figure is much higher. Once you expand your investment universe to include international stocks, it becomes obvious that the only way to effectively diversify a portfolio is through the use of mutual funds.

However, even when individuals invest in mutual funds, they typically don't diversify effectively because they make the mistake of thinking that diversification is about the number of funds you own. Instead, it's about how well your investments are spread across different asset classes. For example, an investor who owns 10 different actively managed U.S. large-cap funds may believe that he is effectively diversified. While it's true that each fund will likely have some differentiation in its holdings from the others, collectively, all the investor has done has been to create an expensive "closet" index fund. The reason is that it's likely that the return of his portfolio, before expenses, will approximate the return of an S&P 500 Index fund. After expenses, the odds are great it will underperform.

Even many individuals who invest in index funds get it wrong because they limit themselves to funds that mimic either the S&P 500 Index or a total U.S. market index. At the very least, they should also include a significant allocation (30 percent to 50 percent) to a fund such as Vanguard's Total International Stock Index Fund.

The next step is to show you how simple it is to build a more effective, globally diversified portfolio. Many investors think that diversification means owning enough mutual funds. However, the key is spreading them across asset classes. After all, 10 different large-cap growth funds still means you only have exposure to one asset class.

The Basic Portfolio

We will begin with a portfolio that has a conventional asset allocation of 60 percent stocks and 40 percent bonds. The time frame will be the 38-year period, 1975-2012. This period was chosen because it's the longest for which we have data on the indexes we need. While maintaining the same 60 percent stock/40 percent bond allocation, we'll then expand our investment universe to include other stock asset classes.

We begin with a portfolio that consists of just two investments:

We'll see how the portfolio performed if one had the patience to stay with this allocation from 1975 through 2011 and rebalanced annually. We will then demonstrate how the portfolio's performance could have been made more efficient by increasing its diversification across asset classes. We do so in four simple steps.

Portfolio 1

By changing the composition of the control portfolio, we will see how we can improve the efficiency of our portfolio. To avoid being accused of data mining, we will alter our allocations by arbitrarily "cutting things in half."

Small-Cap Stocks

The first step is to diversify our stock holdings to include an allocation to U.S. small-cap stocks. Therefore, we reduce our allocation to the S&P 500 Index from 60 percent to 30 percent and allocate 30 percent to the Fama/French Small Cap Index. (The Fama-French indexes measure returns using the academic definitions of asset classes. Note that utilities have been excluded from the data.)

Portfolio 2

Value Stocks

Our next step is to diversify our domestic stock holdings to include value stocks. We shift half of our 30 percent allocation in the S&P 500 Index to a large-cap value index and half of our 30 percent allocation of small-cap stocks to a small-cap value index.

Portfolio 3

International Stocks

Our next step is to shift half of our stock allocation to international stocks. For exposure to international value and international small-cap stocks we will add a 15 percent allocation to both the MSCI EAFE Value Index and the Dimensional International Small Cap Index.

Portfolio 4

The effect of the changes has been to increase the return on the portfolio from 10.5 percent to 12.3 percent -- an increase of 17 percent in relative terms. This outcome is what we should have expected to see as we added riskier small-cap and value stocks to our portfolio. Thus, we also need to consider how the risk of the portfolio was impacted by the changes. The standard deviation (a measure of volatility, or risk) of the portfolio increased from 10.6 percent to 11.6 percent -- an increase of 9 percent in relative terms. While returns increased 17 percent, volatility increased just 9 percent.

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[Ramdy1978]

Hi Larry,
Interesting stuff. Your opinion on 5-year Treasury Notes is that they are safe? Even in this low interest rate environment? Isn't there a LARGE amount of interest rate risk with those? I don't doubt that this formula would have produced the stated returns in the past, but going forward coule be a whole different story, no? Would a shorter term bond be a safer play at this time?

[investor99]

Larry, great column and an excellent case study of how an investor can use modern portfolio theory in practice. One question for you: I'd like to investigate some possibilities in my own portfolio. Do you know of any calculators or ways I can plug in my own assets and get projected returns and standard deviations of volatility for my own particular mix of funds?

[Jackwriterstl]

Thanks Larry. That's very helpful. Keep up the great work.

[Jackwriterstl]

Hey Larry,
Great post, as always. A couple of quick questions.
1. Why ex-utilities throughout? Not too many broad-based index funds out there that are ex-utiliities.
2. And just to be clear, if I own both a broad large market index fund and a broad small market index fund, presumably both will have roughly a third of those portfolios in value stocks. So effectively, my portion devoted to value will be higher than the 7.5% splits shown here. It would be closer to 10% of your portfolio for small-cap, 10% for large and 20% for international. I just bring it up because I'm sensitive to duplication in my own portfolio. Whether I'm 20% in value or 35% in value makes a difference from a risk perspective. Am I looking at this right?

[LarryswedroeCBS]

Jack
Academics exclude utilities because they have different risk characteristics than other stocks, especially regulated ones. REITS are also excluded, treated as separate asset class.

On value stocks. That figure changes over time, but don't think it is even close to 30%. In 1999, at around peak of the growth bubble, large value was about 6% and small value about 2%.
Back in 1980 it was about 13% large value and 2% small value. Dont' know what it is today, haven't looked lately but I'm guessing probably similar to 1980 levels.


As to 20% or 35% it makes a big difference. First you have higher expected returns if have 35% and not 25%. Second if you have 35% you need to (or can) hold less equity risk than if only 20% value to achieve the same expected return. That is one of the benefits of having more small and value stocks than the market--you can hold less beta risk. And over time if you have done that you have cut the left tail risk much more than the right tail has been cut. You might do search on the "Larry Portfolio." And also here. http://www.bamwebsites.com/581292.pdf

The topic of high tilt/low beta portfolios is also covered in The Only Guide You'll Ever Need to The Right Financial Plan in the appendix.


I hope that helps

Best wishes
Larry

[LarryswedroeCBS]

Artmovement
The data is index returns, not fund returns. And you're correct that costs matter. So you have to consider the benefits of diversifying to other asset classes vs. the costs. I rule of thumb might be don't add if you have to pay say 1% more, or perhaps 50bp, depending on the asset class. The better the diversifier, the more I would be willing to pay.

The best thing to do is to complain to the provider and get better choices. There is no reason not to have low cost funds available in all the major asset classes. My firm works with now close perhaps 700 or more plans and they all have access to relatively low cost passive vehicles.

I hope that is helpful
Best wishes
Larry

[artmovement]

Hi Larry, I want to use the samples you mentioned on my 401K but the only low cost funds are large and small cap index in my 401k. In above samples did you factor in the cost? The international funds cost a lot to maintain. Thanks.