The Most Important Tool of Investing

The Most Important Tool of Investing

Diversification

Today I want to talk to you about what in my opinion is the most important tool an investor can use to his advantage. This tool is diversification. It is the only tool that allows you to reduce the risk in your portfolio, while at the same time not lowering the returns. Even though most people have heard of diversification and you will frequently hear phrases like: “Don’t put all your eggs in one basket!”, there are a lot of misconceptions out there. The concept of diversification appeals to many investors, but especially new ones think buying a lot of different stocks will sufficiently reduce the risk in their portfolios. However diversification can quickly lead to diminishing returns without lowering the overall risk. The biggest reduction in risk comes from the first 10 different stocks. After that, risk is only marginally reduced, while at the same time costs go up drastically. Because many investors don’t understand that, to gain all the upside from diversification, they only need have around 10 stocks they will buy many more thinking they are further reducing their risk. This will lead to a diminishing risk adjusted return, because increasing costs, lowering the return, outpace the marginally reduced risk. This phenomenon is known as over diversification. 

As we have seen in this first paragraph, diversification, if over diversification is avoided, can be a great tool. But there is a whole different level of diversification. Most people focus too much on diversifying across different stocks, sectors or regions. However in this digital age all stock markets around the world a highly correlated. The true power of diversification can be harnessed when diversifying across assets that have a low correlation. This is why it is necessary to diversify across different asset classes that have a low correlation. Diversification in the form of Asset Allocation becomes the most important tool of the investor.

Asset Allocation

Investopedia defines asset allocation as: “… an investment strategy  that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals,  risk tolerance , and  investment horizon . The three main  asset classes  –  equities, fixed-income, and cash and equivalents – have different levels of risk and return, so each will behave differently over time.”. In our case the most important factor in determining the portfolio structure will be correlation. I will show you how different types of asset allocation have played out over the last decades and we will see the power of a well structured portfolio. The tool I will use for backtesting is  www.portfoliovisualizer.com which is a free service.

All Stocks versus Stocks and Bonds

This first section is meant to illustrate to you how big of an impact diversification can have. The portfolios shown are kept really simple to make a point and are for demonstrative purposes only. We will compare a portfolio that consists of US stocks only to one that has an equal mix of US stocks and long term treasury bonds. Long term treasury bonds are a good asset to diversify, because they have a correlation to US stocks of only 0.04 and are therefore almost independent of the stock market. In the table below you can see the comparison of the two portfolios for a period from 1978 to 2019. What you can see is that by allocating 50% of your portfolio to long term treasury bonds it was possible to massively reduce the risk and only giving up very little upside. The risk in terms of the maximum drawdown more than halved from -50.89% to -20.39%. Also the worst year delivered a performance of -7.26% compared to an all stocks portfolio with a worst year of -37.04%. Contrary to this development the return, measured as the compound annual growth rate, only went down by 0.95%. (As a side note: You can see the power of compounding, because even though the return only went down by 0.95% it makes up roughly one third of the end balance over this long period of time.) In the last row of the table you can see that it was possible to generate an annual alpha of 4.33% simply by adding bonds and without any stock picking. That means the portfolio that mixed stocks and bonds was able to generate a risk adjusted excess return of 4.33% per years compared to the broad US stock market over the same period of time.

Examples of Asset Allocations

The purpose of this section is to introduce you to different types of asset allocations to give you an idea of how professional investors use this concept to their advantage. Below you can find a table that compares these allocations to each other as well as to US stocks. For each allocation there will be also a pie chart to show you how they allocate their capital.

All Seasons Portfolio

This asset allocation goes back to Ray Dalio the founder of Bridgewater Associates (see sources). The goal of this allocation is to invest in asset classes that thrive in complementary environments. For example during inflation bonds would suffer losses, but gold would perform well and during an economic downturn stocks would suffer, but bonds would perform well. You can find the exact allocation in the pie chart in the slider below.   The only change I made is to allocate 15% to gold as the original portfolio allocates 7.5% to gold and 7.5% to other commodities. However it doesn’t make a big difference as it is the same asset class and there is a lot more data on gold. The reason behind the high weighting of treasuries is their low volatility compared to stocks. The goal is to have an equal influence of all asset classes, so bonds have to be given a higher weight. The compound annual growth rate of this portfolio is 9.46% for the period from 1978 to 2019. However the really special characteristic are its low drawdowns. The maximum drawdown was only -13.06% and the worst year only -4.46%. Contrary to that the best year, with a performance of 31.9%, came close to the performance of an all stocks portfolio. Dangers to this allocation in the future could be high government debt and low yields of treasuries. 

 

Equal Weight Portfolio

This portfolio has the same goal as the all seasons portfolio, but allocates its capital equally among the asset classes and also includes cash. Because cash doesn’t generate income and the risk portion (stocks) only makes up 25% compared to 30% in the all seasons portfolio, the return is lower. The advantage of a cash position is the liquidity that goes with it. This liquidity can be really helpful. You can either sit out downturns without having to sell assets or you could even use low prices to buy more assets. This allocation would also offer more protection against a systemic crash with 50% either being allocated to gold or cash. Which asset allocation you prefer comes down to your personal preferences and expectations.

Conclusion

Asset Allocation is the most important decision an investor has to make. Combining multiple asset classes that preferably have a low correlation will tremendously reduce risk and therefore enable the investor to achieve a superior risk adjusted return. Inside the asset class of stocks further diversification can be obtained by selecting multiple companies to invest in. However it is imperative to limit oneself to roughly 10 stocks and thereby avoid over diversification. Further we have seen two examples of portfolios that both use asset allocation to massively reduce risk. These portfolios are an orientation for the reader and meant to give him a feeling for how an asset allocation could look like and what to expect from it. I hope I could provide some interesting insights and you enjoyed reading.

 

 

Sources:

https://www.investopedia.com/terms/a/assetallocation.asp

https://www.portfoliovisualizer.com

Ray Dalio Interview in: Money: Master the Game by Tony Robbins

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