Chart of the Week: The value of diversification in two charts

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Jan 28, 2020
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Chart of the Week, Investing, Index Funds

What makes investment diversification so difficult for us mere mortals is that you will never feel like you have the optimal portfolio and have that nagging frustration of "what if...". For example, while many investment professionals encourage investors to have some exposure to international stocks in their portfolio, that has not been a winning strategy for the past decade as the U.S. stock market has vastly outperformed the rest of the world as this chart indicates:

Note: MSCI ACWI is an all country index and in this chart excludes U.S. indexes

So, for those who diversify in this way, a decade can seem like a long time for one part of your portfolio (U.S.) to outperform the other (non-U.S. stocks). Thought bubble: What if...I only owned U.S. stocks?" Given the uncertainty that we all accept as investors, some wonder if the decade ahead will see international stocks outperform as a smattering of headlines seem to suggest. Meanwhile, others in disgust will decide it's time to throw in the towel on international and double down on U.S. stocks. 

The other form diversification takes is the division (or allocation) between stocks and bonds. This is actually a main determinant of how your portfolio will do; this decision between how much to put in stocks vs. bonds. For the past decade the winning strategy has been 100% stocks as the longest bull market in stocks continues to roll on into 2020. If you've owned bonds over the past decade, you feel the frustration of knowing "I could have earned more if I only had more stocks." Of course, that's hindsight bias (a.k.a. Monday Morning quarterbacking) as when the decision was made, we couldn't know the outcome that followed. 

This post from bps and pieces blog takes a 20 year view of diversification comparing performance of an S&P 500 stock index with a diversified portfolio (60% Stocks and 40% Bond Index). Note the emotions (emojis on the right) that the investor who diversified would have felt over these time frames. They never seem to be be satisfied. Yet, with all of the ups and downs experienced over the 20 year period, the diversified portfolio actually outperformed the S&P 500 portfolio. Why? As the chart indicates, investors who were diversified saw their portfolios lose less money during the 2000-2002 and 2008 stock market meltdowns when holding bonds provided ballast to their plunging stocks. 

I think the blogger sums up how you might want to think about diversification and stop thinking about the "what ifs..."

 

Questions:

  • When did the diversified portfolio (60% stocks, 40% bonds) have better returns than the S&P 500 (stocks)? 
    • Do you see a pattern here? 
  • Do you think it's difficult to own both stocks and bonds when you see that stocks are rising so much?
  • Over this 20 year period, which portfolio did better? Does this chart make the case for/against having a diversified portfolio?

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Here's another chart that shows the value of diversification. Track these individual asset classes over a 20 year period and you see a patchwork in which the relative performance of these assets are literally "all over the map."  The idea of predicting which ones will do best in a given year is pure folly (click for PDF). The solution is easy: diversify!

Question:

  • Do you see any pattern in the returns of these individual asset classes? 
  • How often do you find the best performing asset class in one year ends up being the worst the following year: "from first to worst"? How about from "worst to first"? 
  • Do you think it's easy to predict which assets will do well in a given year? Use evidence from this chart to bolster your argument. 

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Want to learn more about index funds? Be sure to check out NGPF's investing unit and the multiple activities there including Let's Make A Mutual Fund and What's the S&P 500? 

 

About the Author

Tim Ranzetta

Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.