An Illustrated History of Why Diversification Works

The picture below could be worth tens of thousands of you.

What you have before you is the most colorful, explanation for why diversification works. (If you're having trouble reading the text, you can download the Callan Periodic Table of Investment Returns directly from Callan Associates.)

Each color represents an index; white is the MSCI EAFE index of foreign stocks, blue is the S&P 500, green is the Barclays Capital Aggregate bond Index. The randomness of the color pattern is an eloquent argument for diversification; there's not exactly a consistent pattern to stake your money on. You're a lot better off owning a diversified portfolio across those asset types, rather than trying to make an outsize bet for or against any one slice.

It's A Great Cure for Performance Chasing, Too.

You might want to print out the table out and keep it handy the next time you're tempted to jump on the latest hot investment fad. Check out bonds (green) in 2002 and then in 2003. Or Foreign Stocks (white) in 2007 and then 2008. Of course, there's no law that says this year's winner must be next year's loser. Sometimes what's hot stays hot for a while. Check out U.S. Growth Stocks (Raspberry) from 1995-1998...then see where they landed soon after.

"Normal Grinding of Regression to the Mean."

This annual table from the folks at Callan Associates popped into my mind while I was reading the latest quarterly commentary from GMO. Chief investment strategist Jeremy Grantham revisited his firm's now-prescient 1999 call that the next 10 years would be far from profitable:

We forecast then that the egregiously overpriced S&P would underperform cash and everything else â€" what should you expect starting at 33 times earnings? â€" and we assumed that emerging equities would do extremely well despite a 0.7 correlation with the S&P, because they were cheap. The efï¬?cient market people, who apparently will take their faith with them to the grave, will say we were lucky, in spite of the one in several hundred thousand odds of being correct. "Preposterous. How can the risky asset underperform cash for 10 years?" you can hear them say. But we would say it was just the normal grinding of regression to the mean.

Regression to the mean: What ventures out to an extreme (positive or negative) will eventually move back toward it's normal range. In 1999 Grantham was looking at the frothy valuations for U.S. stocks, scoffed at the notion of a new paradigm and instead staked client assets on a return to historical valuation norms.

[If you're not familiar with GMO's detailed 10-year asset class forecast from late 1999, be sure to download the letter linked above; it includes that forecast and actual returns through 2009.]

Grantham would be the first to tell you that the challenge is to patiently wait for the regression to occur. There is no law that says what is wildly overpriced or underpriced this year must revert next year. As he writes in his recent letter:

"It's an awfully normal world we inhabit, in the long term. It's only the short-term zigs and
zags that drive us all crazy."

Keeping regression to the mean in mind, is a good way to protect yourself from getting too caught up in the short-term craziness and focused on what will work for you and your portfolio over the long-term.

Table courtesy Callan Associates