A basic principle of investing is that the higher return an investment pays, the higher the
risk of the investment. And, if you want low risk, you must expect lower returns. We all
expect stocks to return more than bonds but nearly everyone knows that higher returns
bring higher volatility. Fixed income investments, with their lower returns than stocks are
less volatile, hence less risky.
Whenever a client calls touting some great new investment that promises to pay 12%
-14% or more, “guaranteed”, we are immediately suspicious. In every such situation
we’ve experienced, there has been a significant risk associated with the investment.
The more risk you take on, the greater the chance of losing money. Warren Buffet,
considered by many to be the greatest investor of all times, abhors losing money. His
Rule # 1 is “Never lose money”. His rule # 2 is “Never Forget Rule # 1.” Consider that if
you lose 50% of your principle, you must achieve a 100% return to recover your losses.
So how do you go about lowering risk and reducing the chances of losing money? And,
is there a way to lower risk and increase returns at the same time, contrary to the basic
principle discussed above? Fortunately, the answer is yes! It’s called diversification.
Proper diversification of your portfolio can boost your portfolio’s returns and at the same
time lower the risk (volatility) of the portfolio.
Clients often come to us with a portfolio made up of a large number of stocks and mutual
funds and believe that they are well diversified. Often their portfolios may contain some
cash, one or two bond funds, maybe one or two international funds and a number of
large domestic stock funds. More often than not, the stock mutual funds overlap, (i.e.
they each invest in many of the same individual stocks). It’s not unusual for clients to
have 60%-80% of their total portfolio invested in large company U.S. stocks. That’s not
what we consider proper diversification.
To be properly diversified, you need to be invested in several distinctly different asset
classes. We include nine different asset classes in our clients’ portfolios. These include
cash or cash equivalents, short-term bonds, high-quality intermediate-term bonds, high
yield bonds, international bonds, large domestic stocks, small domestic stocks,
international stocks and real estate equities. We utilize broadly diversified no-load (no
commission) mutual funds, Exchange Traded Funds (ETFs) and index funds.
You may be wondering: “Why does diversification increase returns and lower risk?”
Warren Buffett might say that it’s due in part to the fact that diversification reduces
investment losses (Remember Warren’s Rule #1?). The distinctly different asset classes
noted above experience different up and down cycles. Thus, real estate equities may
be in their up cycle while other stocks are in their down cycle. Bonds may be doing
poorly while stocks are rallying. International stocks may be up while U.S. stocks are
down. The returns of these various asset classes are not strongly correlated, meaning
that they move somewhat independently of each other.
The next logical question is: How much of an effect does diversification have? Well
known speaker and investment manager, Roger Gibson, in his book “Asset Allocation:
Balancing Financial Risk”, Dow Jones-Irwin, Homewood, Illinois 1990, cites a study of
the performance of what he describes as a “traditional portfolio” versus the performance
of what he calls a “broadly diversified portfolio”. The “traditional portfolio” includes only
Treasury Bills, corporate bonds and S&P 500 stocks. The “broadly diversified portfolio”
includes the same asset classes as the “traditional portfolio” plus international bonds,
small company stocks, international stocks and real estate equities.
During a 10-year period ending 1988, the ‘traditional portfolio” returned 13.9% versus
15.3% for the “broadly diversified portfolio”. And, the higher return of the more
diversified portfolio was accompanied by 0.8% lower risk as measured by the portfolios’
standard deviations (a statistical measurement generally equated to investment risk).
Over 16 years ending 1988, the “broadly diversified portfolio” returned 12.3% versus
9.9% for the “traditional portfolio” with 0.9% lower risk.
So, if you want to pursue Warren Buffet’s Rule # 1, make sure your portfolio is broadly
diversified. You can improve your portfolio’s return and at the same time lower your risk!
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, September 2007, Re-titled as: Diversify for Higher
Returns with Lower Risk
Higher Returns with Lower Risk
By David and Erin Patterson