The single greatest misperception we encounter with clients, and many Advisors as well, is the idea that material diversification can be achieved with a large number of individual stocks or stock mutual funds. This just isn’t true; further, it is less true now than ever because of high average stock correlations within and across markets.
In order to achieve true diversification, and the critical advantage this provides – lower volatility – it is essential to diversify across asset classes. That is, your portfolio should at the very least hold some stocks and some bonds, and a material portion of your bond holdings should be high quality government bonds because these are the only assets whose diversification benefits increase when all other markets are in crisis.
To illustrate the misperception about stock diversification and emphasize the importance of asset class diversification, we created two portfolios out of 5 major markets and tested their performance back to 1995:
- The All-Stock Portfolio consisted of equal weightings in U.S. (SPY), EAFE (EFA) and emerging market (EEM) stock indices, rebalanced quarterly.
- The Asset Class Portfolio consisted of equal weightings in U.S. stocks (SPY), U.S. long Treasury bonds (TLT), and gold (GLD).
Note that the All-Stock Portfolio consists of 2277 of the largest stocks from around the world, so it is about as diversified as it is possible to be in stocks alone. It is certainly much more diversified than any individual’s stock portfolio, or any individual or basket of stock mutual funds.
The chart below shows three important pieces of information:
- The actual daily realized volatility of each market. For example, the volatility of EEM over the period was 28.3% annualized.
- The average of the individual volatilities for the three markets in each portfolio. For example, the ‘Average of Stocks’ bar shows the average of the volatility for each of EEM, EFA and SPY: (28.3% + 22.1% + 20.9%)/3 = 23.8%. This approximates what the volatility would be if there were no diversification benefit of holding all three markets in a portfolio.
- The actual average observed volatility of each portfolio. This number captures the volatility after realizing the benefits of diversification. For example, the actual average observed volatility of the All-Stock Portfolio was 21.8%.
