Consider Diversification When Investing for the Long Run

Last Updated May 11, 2009 8:39 PM EDT

My colleague Patrick McDevitt wrote an excellent article discussing Jeremy Siegel's book Stocks for the Long Run and the concerns with that philosophy given the recent market turmoil. He's right about investing in stocks because it suits your needs and not because you think they're less risky over the long term. But you also need to consider the effect of diversification over the long term as well.

Let's use the same 20-year period as Patrick (ending March 2009), and start you with a 100 percent equity portfolio, represented by the S&P 500. During this period, the portfolio returned 7.4 percent per year. It's true that long-term government bonds outperformed the S&P 500 during this time, but why would you have guessed that? In the previous 20 years, stocks outperformed bonds nearly two to one -- 6.8 percent versus 3.5 percent.

Instead, consider the effects of diversifying the portfolio. By making the portfolio 60 percent S&P 500 and 40 percent long-term government bonds, you'd raise the return to 8.7 percent per year while lowering the portfolio's volatility by nearly one-third (14.9 percent to 10.0 percent).

Stretching the time period to 30 years gives you an even better perspective of the benefits of diversification. For the 30-year period ending March 2009, the S&P 500 returned 10.3 percent per year, and long-term government bonds returned 10 percent per year. However, a portfolio of 60 percent S&P 500 and 40 percent long-term government bonds did better than either alone, with an average return of 10.6 percent per year. And it even did this with less volatility than government bonds alone, with a standard deviation of 11.1 percent versus 11.5 percent for the bonds.

This is why it's important to never consider the returns of an asset class in isolation. Instead, asset classes should also be judged on their diversification benefits and the effects additions would have on your portfolio.

Further reading: Another MoneyWatch colleague, James Picerno, gives you the full Dish on Diversification.
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    Larry Swedroe is a principal and director of research for the BAM Alliance. He has authored or co-authored 12 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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