Why Diversifying Your Portfolio Works

Posted on: 5th October 2016 in Holborn Assets

Taking a case study of the Japanese stock market, Holborn Assets shows how diversification can protect your own investment in a poor decade to come of stock market returns. Key Points:

• Historically, the average 10-year stock market return has been extremely variable.
• It’s not uncommon for 10-year stock returns to be low, and sometimes even negative.
• Japanese stock returns have been very low over the past 30 years.
• Broad diversification would have greatly benefited Japanese investors in recent decades.
• Market conditions over the next 10 years will likely favour diversification beyond stocks and bonds.

The U.S. has been one of the best performing stock markets over the past 100 years, no doubt a product of how strongly its economy has grown over that period. The chart below shows the performance of U.S. stocks (S&P Composite Index) going all the way back to 1871. Had you invested $1 back in 1871, today it would be worth over $275,000. That’s a 9% annualised return (nominal). Unfortunately, very few investors have an investment horizon of 145 years. 

So, what do the returns of U.S. stocks look like over shorter holding periods?  How about a more reasonable holding period of 10 years?   The chart below shows the rolling 10-year annualised returns for U.S. stocks — again, going back to 1871.  The average 10-year annualised return over this period was 9.2%, almost the same as the very long-term return.  As can be seen, however, the variability of 10-year returns is very large, ranging from a maximum 10-year annualised return of 21%, to a minimum five-year annualised return of -4%. So, even over a 10-year period, (a timeframe that most people would consider ‘long-term’) stock market returns can range from very good, to very low, and sometimes even negative.  Of course, the figures above only relate to U.S. stocks.  But the U.S. stock market has been one of the strongest performers over the past 100 years, so the data above is likely better than a lot of other stock markets.  

One stock market that certainly hasn’t fared as well as the U.S. is Japan.  As the chart below shows, over the past 30 years, broad Japanese stocks have generated a measly 1% annualized return.  Put another way, had you invested in Japanese stocks back in 1986, your initial capital would have grown by just 34% as of today.  Worse still, Japanese stocks are actually significantly below (35% below) where they were in late 1989. This means Japanese stocks would have to increase by 50% from current levels just to get back to where they were 27 years ago. 

History tells us, therefore, that long-term stock market returns are not always strongly positive; returns can be very low, or even negative in extreme cases.   The best way to protect against these low returns, of course, is to diversify. To see how diversification would have benefited a Japanese investor over the last 30 years, we’ll examine the performance of a number of different portfolios, each with varying degrees of diversification. Firstly, what if a Japanese investor had allocated all their capital to Japanese stocks?

100% Allocation to Japanese Stocks

As we saw in the chart above, had an investor allocated all of the capital to Japanese stocks over the last 30 years, their returns would have been very low. Not only that, those low returns would have come with high volatility, 20% annualised, and very large drawdowns, the largest of which was a decline of -68%.  Investors in Japanese stocks over the past 30 years, therefore, have had to endure lots of pain, for very little gain.

60% Japanese Stocks / 40% Japanese Bonds

What if an investor had diversified their capital across both Japanese stocks and Japanese bonds?  The table below shows the performance of a Japanese 60/40 Portfolio, with a 60% allocation to Japanese stocks and a 40% allocation to Japanese bonds:

The annualised return of the Japanese 60/40 Portfolio was a higher 2.7%. Additionally, volatility (12%) and the maximum drawdown (-37%) were lower than the Japanese Stocks Portfolio. The chart below compares the performance of the two portfolios:   The Japanese 60/40 Portfolio is an obvious improvement on the Japanese Stocks Portfolio. But, on an absolute basis, a 2.7% annualised return is hardly impressive, especially given that an investor would have had to endure a -37% drawdown to get that rather low return.

Global 60/40 Portfolio

What if an investor had diversified outside of just Japanese stock and bonds?  The next portfolio is again comprised of 60% stocks and 40% bonds, but this time the allocations are split between both Japanese and global assets. Specifically, the Global 60/40 Portfolio consists of: 30% Japanese stocks, 30% global stocks, 20% Japanese bonds, and 20% global bonds. How did this portfolio perform over the past 30 years?

The Global 60/40 Portfolio outperformed the other two portfolios, generating an annualised return of 4.4%. This is unsurprising, because most other stock markets have performed much better than Japanese stocks over the past 30 years; the same goes for Japanese bonds versus other bond markets.   The volatility of the Global 60/40 Portfolio was slightly lower than the Japanese 60/40 Portfolio, while the maximum drawdown was slightly larger.  

Diversified Portfolio

Finally, what if an investor had diversified their portfolio holdings even more broadly?  The Diversified Portfolio is comprised of equal holdings of stocks, bonds, gold, managed futures and cash (short-term government Japanese bonds).  Specifically:

• 10% Japanese Stocks
• 10% Global Stocks
• 10% Japanese Bonds
• 10% Global Bonds
• 20% Gold
• 20% Managed Futures
• 20% Cash (short-term Govt. bonds)

As the table below shows, the annualised return of the Diversified Portfolio was 4.8%, an improvement on the performance of the Global 60/40 Portfolio.  Significantly, however, the volatility of the Diversified Portfolio was just 6%, much lower than the other portfolios.  Also, the maximum drawdown of the Diversified Portfolio was a much more tolerable -14%, significantly lower than the drawdowns of the other portfolios.

The lower volatility and drawdowns of the Diversified Portfolio can be seen in the following performance comparison chart:   Clearly, diversification would have certainly helped Japanese investors over the past 30 years, with broad diversification providing the best results. Of course, broad diversification doesn’t always result in the best performance. Diversified portfolios will inevitably underperform in a strongly performing stock market, or, for that matter, any strongly performing asset. As an example, take U.S. stocks over the last 30 years, which have generated a 9.4% annualised return, slightly above their very long-term average. How did the equivalent diversified portfolios examined above perform for a U.S. investor?

  As you can see, for U.S. investors, the performance of the Diversified Portfolio was lower than the pure U.S. Stocks Portfolio, as well as the U.S. 60/40 and Global 60/40 portfolios.  This is unsurprising given the performance of U.S. stocks over the past 30 years, which also coincided with a strongly performing bond market. Despite its lower returns, however, the Diversified Portfolio still generated acceptable performance, as well some big benefits: it had the lowest volatility and by far the lowest maximum drawdown. So, the Diversified Portfolio may have had lower overall returns, but it provided investors with a much smoother ride. Warren Buffett said: “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” Sure, in an ideal world, armed with a crystal ball, we would know which assets were going to perform well and poorly over the next ten years and so diversification wouldn’t be required.  On the other hand, if future returns are completely unpredictable it makes sense to diversify as broadly as possible (or to stay away from investing altogether).  The reality lies somewhere between these two extremes.  Yes, we can’t be certain about future returns, but there are effective ways to gauge long-term asset performance. So what about the next 10 years? Well, with bond yields so low and stock valuations on the high side, particularly in the U.S., the returns on these assets over the next decade are likely to be a lot lower than in recent years. This doesn’t mean things are going to be as bad as they have been in Japan. On the other hand, things almost certainly won’t be as good as they’ve been in the U.S. over the last 30 years. What we can say is that market conditions will likely favor a broadly-diversified portfolio approach over the next 10 years.  There’s no guarantee that a broadly-diversified portfolio approach will perform better than less diversified approaches, but the odds strongly support this view. This is why the investment approach employed by the Holborn Portfolios emphasises broad diversification across a range of assets and investment types.