2277 Stocks and Still Not Diversified?
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:
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:
Markets that are held in the All-Stock Portfolio are underlined in red, while assets that are held in the Asset Class Portfolio are underlined in green. ETF symbols which track the markets are used in the chart rather than the full name of each market to save space (see symbol guide above).
Source: Butler|Philbrick|Gordillo & Associates. Data from Yahoo.
The average volatility of the individual stock market indices is 23.8%, but when we assemble them in a portfolio the portfolio volatility decreases slightly to 21.8%. The difference, 2%, represents the free lunch that results from the fact that the three stock indices do not move in perfect synch; that is, they are not perfectly correlated, so combining them produces a small diversification benefit. The percentage improvement to portfolio volatility - the diversification advantage - from combining international stock markets is about 8.4% [(21.8% - 23.8%)/23.8%], which is nice, but hardly comforting.
In contrast, while the average volatility of the individual asset class indices is lower at 16.5%, when we assemble them in a portfolio the portfolio volatility drops very substantially, to 9.1%. We can therefore infer that combining different asset classes in a portfolio produces a diversification advantage of almost 45%.
In other words, asset class diversification provides over 500% more diversification than diversifying across stock markets alone (45% vs. 8.4%).
Lest you assume that the Asset-Class Portfolio must have earned lower returns because of its much lower volatility, take a look at the following chart which adds annualized returns and maximum portfolio peak-to-trough drawdowns to our dataset. The Asset-Class Portfolio delivered over 50% better returns and less than half the drawdown of the All-Stock Portfolio over the time period considered.
Source: Butler|Philbrick|Gordillo & Associates. Data from Yahoo.
Adam Butler and Mike Philbrick are Portfolio Managers with Butler|Philbrick|Gordillo & Associates at Macquarie Private Wealth in Toronto, Canada.
(c) Butler|Philbrick|Gordillo & Associates, 2011 GestaltU
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