Do you really need portfolio diversification? Whether it be a retirement account, individual taxable account, an educational account, a 401K, or more, the question of portfolio diversification is often raised. Everyone assumes that broad asset class portfolio diversification is advantageous. The major benefit is to reduce the risk associated with events that can trigger a decline in any one asset class. By holding a variety of asset classes that are mostly uncorrelated with one another, the investor hopes to avoid those catastrophic occurrences that completely wipe out years of gains, such as what happened during the credit crisis of 2008. Further, portfolio diversification makes financial planning more reliable and predictable by reducing the variations in portfolio performance from year to year.
Simply put, portfolio diversification is a sound investment practice. But exactly how much risk reduction, in actual numbers, is obtained through application of this philosophy? That was the question I was pondering and was wondering if, indeed, asset class diversification is all that it’s cracked up to be.
Setup
The ideal tool for performing the analysis in this article is Modern Portfolio Theory (MPT). This Nobel Prize-winning approach utilizes complex mathematics to tell you how to best allocate your funds among various asset classes to minimize risk.
Risk can be looked at as fluctuations in portfolio returns. In MPT, risk is measured by a statistical term called the standard deviation. It is this quantity that MPT seeks to minimize in recommending portfolio diversification allocations. (The software used in the analyses conducted here is the SMC Analyzer. Click here for more info.)
The portfolios considered here used monthly total return data taken from January 1928 through Dec 2017 for each of the following 10 asset classes:
Each of these asset classes are themselves composed of a broad diversification of assets within that class. This article does not address that need, only the benefits of diversification among various classes.
Baseline
The methodology used in this analysis was to first establish a baseline return/risk table using all 10 candidate asset classes (Table 1 below). You’ll see that the table contains certain measures of risk defined as follows:
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