Whenever we write about investing, we always talk about diversification and how
important it is. Over and over again we tell our readers and our clients that being
broadly diversified is critical to their investing success. We claim that diversification
increases portfolio returns while at the same time lowering risk (as measured by portfolio
volatility).
Normally, higher returns come with higher risk. In our recent article titled “If It Sounds
Too Good It Probably Is” (You can view this article on our website by clicking on our “In
the News” webpage – see link below), we explained that when unusually high returns are
promised, it’s likely that the investment is highly risky or possibly even a scam. Yet the
proper amount of diversification, does actually increase returns and at the same time
lower risk.
Diversification doesn’t mean just holding ten or twelve stocks. Sure, ten or twelve stocks
provides more diversification than just two or three stocks. To be broadly diversified,
however, you need to hold a broad array of distinct asset classes whose returns are
uncorrelated. And for even further diversification, within those asset classes, you need
to invest in broadly diversified mutual funds, exchange traded funds (ETFs) and index
funds.
We have modeled our investment strategy after the approach presented in Roger
Gibson’s book Asset Allocation, 4th Edition. Gibson makes a compelling case for
diversification in his book by presenting a group of fifteen equity (stock) portfolios and
asking which would be most preferable to own.
Four of the fifteen portfolios were each made up of a single asset class (U.S stocks,
international stocks, real estate investment equities and commodities, respectively). Of
the fifteen portfolios, these four had the lowest return and highest volatility (risk) of all
fifteen portfolios. (Note: portfolio risk was measured by the statistical measure known
as standard deviation and the returns were measured over the period from 1972 to
2004.)
There were six other portfolios made up of all combinations of exactly two of the four
asset classes that made up the four single asset-class portfolios already discussed (e.g.
U.S stocks and international stocks, U.S stocks and commodities, etc). They generally
had a higher return and lower risk than the four portfolios containing a single asset
class.
There were another four portfolios each made up of the distinct combinations of exactly
three of the single asset classes. They had higher returns and lower risks as a group
than the six portfolios made up of two asset classes.
Finally there was one portfolio that consisted of all four of the single asset classes used
to make up the other portfolios. This portfolio had a higher return and lower risk, overall,
than the four portfolios made up of three asset classes.
Gibson’s group of portfolios showed very clearly that diversification can increase returns
and lower your portfolio risk. If your portfolio is not adequately diversified, we highly
recommend you seek competent professional help to make the changes necessary.
David C. Patterson, CFP® and Erin Patterson-Preston, 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, May, 2008, Retitled: Believe It - Diversification Really
Works
Diversification Really Does Work
By David Patterson and Erin Preston (formerly Patterson)