Part 3 Building Portfolios: Diversification without the Heartburn
- Adding diversifying assets to portfolios of mainstream stocks and bonds can improve expected returns and lead to better long-term investment outcomes.
- Finding the diversifying mix a client is comfortable living with over the long term is crucial to a diversifying strategy’s success.
This article is the third in a series designed to help financial advisors successfully address the challenges associated with the management of their clients’ portfolios by merging key lessons from investment science and behavioral finance. In the first two articles of the series, our colleagues laid out a crucial baseline for this and future articles in the series. They explained how to form reasonable long-term return expectations and why achieving those expected returns is facilitated with a clear understanding of the different risks inherent in an investment portfolio. An informed awareness of both return and risk is essential before we can construct portfolios that meet our clients’ financial goals.
Jonathan loves spicy food. Jim, not so much. Jonathan grew up in Paris, where his mom’s go-to cuisine was Moroccan food, especially tagine, while Jim grew up understanding that a great steak, prepared correctly, has all the flavor it needs without any extra accoutrement. Whether just a dash of salt and pepper or a heaping spoonful of harissa, our individual palates dictate the amount of spice we can comfortably handle. Indeed, in addition to pleasing the senses, some evidence for the health benefits of spicing up meals exists, including recent research suggesting a regular diet of spicy foods is associated with a longer life.1
Like adding spice to a meal, adding asset classes beyond traditional core stocks and bonds to an investment portfolio can induce uncomfortable reactions, starting with the occasional heartburn despite the indisputable benefits of diversification. The decision to construct a diversified investment portfolio requires us to include asset classes beyond the most familiar and mainstream, which can be uncomfortable for many investors. Like adding spice to food, adding diversifying asset classes—to the degree our individual risk tolerance allows—offers the benefit of more rewarding long-term investment outcomes. Adding these asset classes—and just as importantly holding them through the interim periods that give us heartburn—offers investors the potential to reap the benefits of diversification over the long run.
How Much Diversification Is Enough?
The most common objective of individual investor portfolios is to maximize after-tax net-of-inflation (or real) returns, such that those returns are capable of providing the funds for ordinary (and sometimes extraordinary) expenditures when or whenever needed. For many, that means supporting consumption in retirement, after the regular paychecks have ended. Most advisor–client conversations typically include a discussion around portfolio diversification as a means to assist in meeting this objective, among others.
The aspects of diversification that advisors typically stress to their clients include:
1. Diversification is a long-term strategy. Over shorter horizons, particularly in volatile markets, we must remember the long-term value proposition of diversification.
2. Diversification is not an all-or-nothing choice. We can put diversifying asset classes into the current portfolio mix to the extent we are capable of tolerating the inevitable short-term discomfort.
3. Finding the right allocation to diversifying asset classes helps avoid the costly but common practice of rotating into and out of diversifying strategies at the wrong times.
Diversification and its long-term benefits have been accepted as a core investment insight over the last 50 years. But in recent years, many have begun to question the benefits of diversification. The main reason for this is the recent pummeling of most diversifying asset classes. The eight-year market rally in US stocks—the second-longest bull market in the past century—has made it very tempting for investors to abandon the pursuit of diversification or retreat to the widely adopted 60/40 portfolio. And why not? Recent returns of a US 60/40 portfolio have been outstanding—7.7% and 10.0% annualized over the last three and five years, respectively—particularly when compared to a sample diversifying portfolio with returns of 1.6% and 1.0%, respectively, over the same intervals.
Most investors are aware of the benefits of diversification from a risk-reduction perspective. This is, absolutely, one of its great benefits, however, in this article, our focus is primarily on diversification as a means of return enhancement. We take this perspective to be consistent with a question we often hear from investors and advisors—How can I make more money for accepting the same amount or risk?—as opposed to—How can I make the same amount of money taking less risk?