Tracking the Benefit of Diversification through “The Lost Decade” of 2000-2009

Tracking the Benefit of Diversification through “The Lost Decade” of 2000-2009

David Kuenzi, CFP®, Thun Financial Advisors, Copyright © 2017

 

Introduction

At Thun Financial Advisors, we believe that proper diversification is the single most important principle of successful investing. Nevertheless, it is actually quite rare to find an investor who has a fully diversified investment portfolio. Many investors who believe they are diversified are at best only partially diversified.

Frequently, we find investors who are not just under-diversified, but who are thoroughly un-diversified. Under-diversification typically takes the form of too much cash; over concentration in stocks; over-concentration in US stocks; no exposure to commodities, small cap stocks, emerging markets or real estate. In some cases, an investor has all their money invested in just a few stocks and/or bonds, often timesin the same country and industry sector.

At best, failure to fully diversify implies that an investor is likely to suffer lower rates of return for the amount of investment risk being assumed than would be the case with greater diversification. At worst, heavy concentration of a portfolio in just a few investments exposes an investor to a catastrophic loss due to the occurrence of a random, unpredictable event such as the bankrupting of Enron or the sudden collapse of a hedge fund, a la Madoff.

 

Importance of Portfolio Diversification

Alternatively, by thoroughly diversifying our portfolios across many different asset classes, we can expect to achieve lower risk and lower volatility than would be the case with a heavily concentrated, undiversified portfolio. And we can do so without having to accept lower expected returns. Diversification is not a guarantee against losses, but gains AND losses will tend to be less dramatic while the average gain over the long-term will be higher when we are fully diversified.

Furthermore, by investing in each of the different asset classes through exchange‐traded index funds (ETFs), we eliminate the risk that any individual company bankruptcy or asset class bear market will put our financial well-being at risk. That is why we call diversification the only “free lunch” in investing. It alters the balance between risk and reward in favor of reward.

To demonstrate how Thun Financial employs this powerful tool on behalf of clients, we looked at the performance of three different portfolios over the 10-year period of 2000 to 2009. Each portfolio is invested across a range of investments, and each portfolio is successively more diversified. The third portfolio is Thun’s Moderate Risk Model Portfolio. Returns are calculated based on the actual return of the underlying funds.

Portfolio #1: This portfolio is 100% invested in a US S&P 500 stock index fund.

Portfolio #2: This is a moderate risk portfolio of 40% US stocks, 30% international stocks and 30% high quality bonds.

Portfolio #3: This is the Thun Moderate Risk Model Portfolio. This portfolio is fully diversified across 14 different asset classes comprised of stocks, bonds, real estate and commodities.

(Please see Appendix for details on each portfolio including 2000-2009 annualized returns per asset class.)

We choose this decade because it was a particularly bad time of investment outcomes for most Americans.  U.S. large company stocks, the asset class that typically dominates most U.S. investor portfolios,  delivered a –10% cumulative return over the entire 10-year period, hence the title “The Lost Decade.”

 

For investors who had a well diversified global portfolio (including a healthy allocation to large U.S. company stocks), however, the decade delivered very reasonable returns.  As the table above clearly demonstrates, the highly diversified Portfolio #3, the Thun Moderate Risk Model Portfolio, delivered a respectable 7% annualized return, better than either the all stock or the stock/bond portfolios. Just as importantly, it did so with lower or equal risk, as measured by the portfolios standard deviation. Furthermore, the Thun Portfolio’s biggest gain year matched the best upside of all three funds even though its biggest loss year did no worse than the worst performance of the three. Equally impressive, over a 3-year period, the Thun Moderate Risk Portfolio generated the best returns and substantially mitigated periods of negative returns as illustrated in the chart below.

 

Part of the reason the Thun Moderate Risk Portfolio did well is because of its exposure to commodities, real estate (REITs) and emerging markets—asset classes which generated better returns than stocks and bonds over the 10 years being considered. This underscores the important role played by non-traditional investments in achieving the full benefit of diversification.  Furthermore, commodities and REITs returns have low correlation to stocks, even though they generate relatively high, stock-like long-term returns. In fact, looking at data back to 1970, commodities actually have had negative correlation with stocks. That is to say, when stocks go up, commodities have tended to go down and vice versa.  So while commodities may not deliver superior returns every decade, they are good long-term investments that can predictably do well when stocks are doing poorly.  The result is reduced overall portfolio volatility and risk.

Conclusion: Results of Diversified Portfolios

By diversifying across stocks and commodities, the volatility of the overall portfolio is reduced, even
though returns are not. (Adding in real estate and bond investments also augments diversiication and
further reduces portfolio volatility.) Going forward, commodities may outperform or underperform other asset classes in any given period. However, they are likely to retain their low correlation to stocks,
and hence act to reduce overall portfolio volatility and risk.

The example of commodities underscores a key principle of sound portfolio construction: to combine different kinds of investments that have relatively high potential return but which are as weakly correlated to one another as possible. Fully exploiting the diversification principle requires investing across the full range of global assets, including stocks, bonds, real estate commodities and their various sub-classes.

 

Appendix

Portfolio holdings, including 2000-2009 annualized returns per asset class

 

Please visit Thun Research Articles for American Expat Investors to find more related information on investing while living abroad.