How to Build a Diversified Portfolio

Writing for The Wall Street Journal, Jonathan Clements noted: "Indexing is a wonderful strategy. It's a shame most folks get it wrong." He was referring to his belief that most investors who use index funds limit themselves to funds that mimic the S&P 500 Index. Today, you'll see how expanding on a simple S&P 500 indexing strategy can improve results. It'll also show you how to outperform the vast majority of institutional investors.

The power of modern portfolio theory will be demonstrated by following the performance of a "control" portfolio, with a traditional asset allocation of 60 percent equities and 40 percent fixed income over the period 26-year period, 1975-2010. This period was chosen because it's the longest for which we have data on the indexes used. Throughout this example, we'll keep the same 60 percent equity/40 percent fixed income allocation.

We will begin with the S&P 500 for the equity allocation and the Barclays Capital Intermediate Government/Credit Bond Index for the fixed income allocation.

First, we'll see how the portfolio performed if an investor had the patience to stay with this allocation from 1975 through 2010 and rebalanced annually. We then demonstrate how the portfolio's performance could have been made more efficient by increasing its diversification across asset classes. Let's see how the first portfolio looked.


A Basic Portfolio


Portfolio 1
  • S&P 500 Index -- 60%
  • Barclays Capital Intermediate Government/Credit Bond Index -- 40%
By changing the composition of the control portfolio through a step-by-step process, we'll see how we can improve the efficiency of our portfolio. To avoid being accused of data mining, we'll alter our allocations by arbitrarily "cutting things in half."

The most important diversification on the equity side is to add an exposure to international equities. Therefore, we reduce our allocation to the S&P 500 from 60 to 30 percent and allocate 30 percent to the MSCI EAFE Index.


Adding International Stocks


Portfolio 2
  • S&P 500 Index -- 30%
  • MSCI EAFE Index -- 30%
  • Barclays Capital Intermediate Government/Credit Bond Index -- 40%
As you can see, adding an allocation to international equities raised the annualized return of the portfolio while keeping the risk the same.

Our next step is to diversify our domestic equity holdings to include small-cap stocks. We shift half our 30 percent allocation to the S&P 500 to a small-cap index.


Adding Small-Cap Stocks


Portfolio 3
  • S&P 500 Index -- 15%
  • Fama/French US Small Cap Index -- 15%
  • MSCI EAFE Index -- 30%
  • Barclays Capital Intermediate Government/Credit Bond Index -- 40%
In this case, both the return and risk rose by adding small-cap stocks. However, the return rose 5.6 percent in relative terms, while the risk only rose 2.7 percent in relative terms, making the new portfolio a more efficient one.

Our next step is to diversify our domestic equity holdings to include value stocks. We shift half our 15 percent allocations to domestic large-cap and small-cap stocks to domestic large-cap value and small-cap value.


Adding Value Stocks


Portfolio 4
  • S&P 500 Index -- 7.5%
  • Fama/French US Large Value Index (ex utilities) -- 7.5%
  • Fama/French US Small Cap Index -- 7.5%
  • Fama/French US Small Value Index (ex utilities) -- 7.5%
  • MSCI EAFE Index -- 30%
  • Barclays Capital Intermediate Government/Credit Bond Index -- 40%
The effect of adding value stocks was similar to the effect of adding small-cap stocks: Both the risk and return of the portfolio went up by 2.6 percent in relative terms. This leads to an individual decision: Are the increased returns worth the increased risk?

Before you answer, keep in mind that we're not yet done. Our next step is to diversify our international equity holdings to include value stocks. (I would have included small-cap stocks here, but the MSCI EAFE Small Cap Index data only goes back to 1999.) We shift half our 30 percent allocation to the MSCI EAFE to the MSCI EAFE Value Index.


Adding International Value Stocks


Portfolio 5
  • S&P 500 Index -- 7.5%
  • Fama/French US Large Value Index (ex utilities) -- 7.5%
  • Fama/French US Small Cap Index -- 7.5%
  • Fama/French US Small Value Index (ex utilities) -- 7.5%
  • MSCI EAFE Index -- 15%
  • MSCI EAFE Value Index -- 15%
  • Barclays Capital Intermediate Government/Credit Bond Index -- 40%

By adding international value stocks to the portfolio, the return rose, while the risk stayed the same. Overall since our first basic portfolio, the effect of our changes has been to increase the return on the portfolio from 10.7 to 12.0 percent (1.3 percent), while increasing the portfolio's volatility from 11.1 to 11.7 percent (just 0.6 percent). In relative terms, we increased the return by about 12.1 percent while volatility increased about 5.4 percent. The result is a more efficient portfolio.

We have one more step to consider. Commodities diversify some of the risks of investing in stocks. They also diversify the risks of investing in bonds. We add a 4 percent allocation to the Goldman Sachs Commodity Index, reducing each of our four domestic equity allocations by 0.5 percent (from 7.5 to 7.0) and both the international equity allocations by 1 percent (from 15 to 14).


Adding Commodities

Portfolio 6
  • S&P 500 Index -- 7%
  • Fama/French US Large Value Index (ex utilities) -- 7%
  • Fama/French US Small Cap Index -- 7%
  • Fama/French US Small Value Index (ex utilities) -- 7%
  • MSCI EAFE Index -- 14%
  • MSCI EAFE Value Index -- 14%
  • Goldman Sachs Commodity Index -- 4%
  • Barclays Capital Intermediate Government/Credit Bond Index -- 40%
The net result of all of our changes is that we now have a portfolio that produced both higher returns and the same volatility, clearly a more efficient portfolio. On an absolute basis, returns increased 1.1 percent (from 10.7 to 11.8) and volatility stayed the same. On a relative basis, returns increased by about 10.3 percent.

Conclusion Through the step-by-step process we just reviewed, it becomes clear that one of the major criticisms of passive portfolio management -- it produces average returns -- is false. There was nothing "average" about the returns of any of the six portfolios we explored. Certainly the returns were greater than those of the average investor with a similar equity allocation, be it individual or institutional.

Passive investing produces market, not average returns -- and it does so in a relatively low-cost and tax-efficient manner. The average actively managed fund produces below market results, does so with great persistency and does so in a tax inefficient manner.

By playing the winner's game of accepting market returns, investors will almost certainly outperform the vast majority of both individual and institutional investors who choose to play the active game. There's only one caveat. Investors must learn to act like a postage stamp. The lowly postage stamp does only one thing, but it does it exceedingly well -- it sticks to its letter until it reaches its destination. Investors must stick to their investment plan (asset allocation) until they reach their financial goals. Their only activities should be rebalancing and tax-loss harvesting.

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