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How a diversified portfolio achieves smoother returns

By October 14, 2020 No Comments

The goal of a diversified portfolio isn’t to provide the highest return possible. Rather, it is to provide the smoothest return possible. There’s a big difference between the two. Consider the following hypothetical graph, which portfolio would you rather own?

A diversified portfolio versus a concentrated one.

The concentrated portfolio achieves a higher rate of return but experiences significant swings along the way. The diversified portfolio provides a little lower rate of return but offers a much smoother ride on the way up. While this may just be a theoretical example, we’ve seen it play out in real life this year.

A Diversified portfolio in action

The Vanguard balanced index fund, VBIAX, is a mutual fund that invests 60% of its assets in stocks and 40% in bonds, qualifying it as a diversified portfolio. Note the fund’s performance during the Covid crash in March compared to a concentrated portfolio, such as the SPY ETF, which tracks the S&P 500. VBIAX declined 11% less than SPY in March but has managed to capture the same type of upside since that time:

A diversified portfolio, VBIAX versus SPY in 2020

Year-to-date, VBIAX is up 10.09% versus a 10.34% return for SPY. Is the 0.25% in excess return that SPY has provided worth the volatility you’ve had to endure? As recently as September, SPY fell 10% from its high point compared to a 5% decline for VBIAX.

Real examples from AGG

A diversified portfolio is not a guarantee against declines in your portfolio just like health insurance is not a guarantee against having to pay something out of pocket in the event you get sick. But if you have health insurance, you will pay less than someone who doesn’t when you need to visit the doctor. In our analogy, bonds have been a form of insurance against stocks for decades.

Even during a two-week panic in the markets from March 9-March 18, which saw both stocks and bonds fall together, bonds fell significantly less. We can see this by comparing an aggregate bond ETF, AGG, to SPY:

In fact, AGG has a history of being a safe investment during some of the worst declines in the S&P 500 so far this century:

safe bond ETF AGG vs SPY 2008

Using bonds to smooth out returns

One of the simplest ways to smooth out your portfolio returns is to include bonds in your allocation. What is an appropriate bond allocation? A good rule is to take the number 110, or 120 for those with higher risk tolerance, and subtract your age. So a 30 year old investor would have an 80% allocation to stocks and 20% in bonds (110-30=80), and a 60 year old would have a 50% allocation to stocks and 50% in bonds (110-60=50).

Why do we subtract from 110? Well, an old rule used to be to subtract your age from the number 100. However, the rule has changed for two primary reasons:

  1. Life expectancy has steadily risen so your nest egg needs to last longer now than ever before
  2. Interest rates have been in a perpetual decline for more than 30 years making it harder to rely on fixed-income investments.

As a result of this, and because stocks have historically outperformed bonds, investors should plan to have some stock market exposure well into their later years. Regardless, this still hits on the idea that bonds can help smooth out your returns and that your risk should decrease as you get older.

How else can you diversify?

Thus far we’ve just touched on the idea of diversification as stocks and bonds, but there are other ways to diversify inside of those allocations. We won’t dive too deep here but we’ll discuss the basics and an example of breaking each of these allocations down further.

The S&P 500 is probably the most well-known stock market index, but there are others as well. Just like stocks and bonds tend to behave differently, there are stock market indices that behave differently from each other as well. For starters, consider this: the S&P 500 owns the 500 largest US-based companies by market value (large-cap stocks) . Another index, the Russell 2000 owns 2000 of the smallest US-based companies by market value (small-cap stocks). Perhaps you can see where I’m going with this… each of these respective indices has performed differently over time. Sometimes large-caps do better than small-caps, and other times its been the opposite:

In recent years, large-cap stocks have performed better than small-cap stocks. However, if you look back further into history, you’ll see that small-caps have done better than large-caps. This type of varying performance inside of a diversified portfolio can help smooth out the inevitable ups and downs that occur throughout the year. Large-caps versus small-caps is just one example. We’ve seen similar cases of varying returns when comparing US stocks to international stocks, or growth stocks to value stocks. The same is true of the bond market where Treasuries can spend time performing better than corporate bonds, or vice versa. This is all just scratching the surface of diversification.

Better decisions with less stress

The goal of a diversified portfolio isn’t to make as much money as possible. It’s to achieve a smoother rate of return. This type of portfolio has benefits that won’t always show up in your investment account. But if you’re the type of person that prefers less stressful investing, then you need to make sure you have a diversified portfolio. It’s very easy to cherry-pick examples of well-known stock winners from the last decade, but the swings investors would have had to endure by holding them is often ignored.

Amazon, for example, has declined at least 30% once per year in 8 out of the last 9 years. Tesla has fallen 34%, 63%, and 52% in the last two years alone. Can you stomach those types of swings? Or better yet, have you gone through it before yourself? Most people say they don’t mind volatility if it helps them achieve a higher rate of return, only to then panic in the middle of an uneasy drawdown. As Jason Zweig of the Wall Street Journal so eloquently stated:

“If I ask you in a questionnaire whether you are afraid of snakes, you might say no. If I throw a live snake in your lap and then ask if you’re afraid of snakes, you’ll probably say yes.”

A diversified portfolio offers protection against snake bites.

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