DiversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. is an important component of any investing plan.  It assists you in limiting your riskThe possibility that something bad will happen. either to a single asset classA group of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors a... More or a single security within an asset classA group of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors a... More.  However, I have seen a couple of graphs from which you could form the wrong conclusions about diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation..  In this post, I show you the charts, identify the wrong conclusion that could be drawn from them, and explain and illustrate the correct conclusion.

Diversification Fallacy #1: A Combination of Stocks and Bonds Provides a Higher Return than just Stocks

I first saw a chart[1] in a post on Schwab’s website a couple of years ago.  It is the first graph on this page.  It was prepared in 2018 and compares the cumulative return on the S&P 500 and a portfolioA group of financial instruments. that is 60% stocks (as measured by the S&P 500), 35% bonds and 5% cash from 2000 to 2017.  I’m not sure why Schwab chose to use an 18-year period for this chart, other than the beginning of the time period corresponds to the turn of the century.  The portfolioA group of financial instruments. is re-balanced annually.  In that chart, the total return on the re-balanced portfolioA group of financial instruments. is slightly higher than the S&P 500 (167% versus 158% or 5.6% vs 5.4% per year).

My Version of Chart

Because I can’t include the Schwab chart here, I created a chart (shown below) that shows a similar result for the same time period.  It compares the cumulative returns on the S&P 500 with those of a portfolioA group of financial instruments. of 60% stocks and 40% 20-year US Treasuries (using an approximation I derived for older years).  The mixed portfolioA group of financial instruments. is re-balanced annually, similar to the calculations in the Schwab chart.

In this graph, the ratio of the value of the S&P 500 at each year end to its value on December 31, 1999 is shown in purple.  The blue line shows the corresponding ratios for the portfolioA group of financial instruments. of 60% stocks and 40% bonds.  The S&P 500 never makes up the losses it experienced in the first few years of this 18-year time period.

Incorrect Inference about Diversification

At first glance, these charts appear to imply that you can earn more if you hold a 60%/35%/5% mix of stocks, bonds and cash (or 60% stocks/40% bonds) than if you invest in just the S&P 500.  That conclusion confused me, as bonds tend to have total returns that are lower than stocks over the long run and cash has close to no return.   If you re-balance your portfolioA group of financial instruments. annually, as assumed in the graph, your total return in each year will be 60% times the return on stocks plus 35% times the return on bonds plus 5% times the return on cash.  Since the returns on bonds and cash are less than the return on stocks, I was sure that the weighted averageA calculation using all of the observations of a variable with each observation being assigned a weight.  The weight is the relative importance of that observation.  Each observation is multiplied b... More of the returns would have to be less than the return on stocks alone.

The Reality

It wasn’t until recently that I figured out why the chart looks the way it does.  The analysis was performed in 2018, so it used the most recent complete 18-year period available.

Historical Perspective

It turns out that period was a rarity in recent history – it was one of only three 18-year periods in which bonds had a higher total return than stocks when considering all such periods from the one starting in 1975 to the one starting in 2002!  If we go back all the way to 1962, the mixed portfolioA group of financial instruments. had higher returns in about a third of the 18-year periods.  The chart below illustrates this point.

Each pair of bars corresponds to an 18-year period (the time period in the Schwab chart) starting in the year shown.  The bar on the left in each pair shows the estimated cumulative 18-year return on a portfolioA group of financial instruments. of 60% stocks[2] and 40% bonds[3] that is re-balanced annually.  The bar on the right shows the corresponding return on the S&P 500 during each period.  As you can see, in most recent years, the right bar (100% stocks) has a higher return than the left bar (60% stocks and 40% bonds).  In older years, the left bar tends to be higher.

How to Use this Information

If your investment goal is to maximize your return without regard to riskThe possibility that something bad will happen., a portfolioA group of financial instruments. with 100% stocks will better meet that objective more than two-thirds of the time when considering 18-year periods and an even higher percentage of the time if you consider only more recent experience.  If interestA charge for borrowing money, most often based on a percentage of the amount owed. rates increase substantially at some point in the future, you might look at the longer time period for deciding whether to add bonds to your portfolioA group of financial instruments., as interestA charge for borrowing money, most often based on a percentage of the amount owed. rates were higher and rose in many of the years from 1962 to 1980.  But you’ll want to wait until interestA charge for borrowing money, most often based on a percentage of the amount owed. rates are a fair amount higher than their current levels before those years are relevant to your decision-making.

If, however, you want to reduce volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results., adding bonds (or other asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value.  The three primary asset classes used by many investors ... More) to your portfolioA group of financial instruments. can help.  My post on diversification for investments provides several illustrations about how the addition of bonds to your portfolioA group of financial instruments. reduces riskThe possibility that something bad will happen., but also reduces your total return.  As you consider using other asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value.  The three primary asset classes used by many investors ... More to reduce volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results., you will need to consider your time horizon for your investments.  As indicated in the chart above, there have been no 18-year periods in the time covered by the analysis in which the S&P 500 had less than a 3% annualized return or 59% compounded return.

Fallacy #2: Diversification in Rank Order Matters

When I first saw this chart from Callan[4], I thought it was very impressed with how it illustrated the benefits of diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation..

The font is small so your probably can’t read the words and numbers, but the visual impact is terrific.  Each column is a calendar year.  Each color corresponds to a different index.  The rows correspond to the order of the returns on each index in each calendar year, with the top row showing the index with the highest return; the bottom, the lowest return.

The indices by color (in the order they appear in the first column) are:

• Rust: S&P 500 Growth
• Olive green: S&P 500
• Grey: MSCI (Morgan Stanley Capital International Index) World ex US
• Dark blue: S&P 500 Value
• Light green: Bloomberg Barclays Aggregate US BondA form of debt issued by government entities and corporations. Index
• Medium blue: Bloomberg Barclays High Yield BondA form of debt issued by government entities and corporations. Index
• Mustard: Russel 2000 Growth
• Brown: Russell 2000
• Light blue: Russell 2000 Value
• Orange: MSCI Emerging Markets

Incorrect Inference about Diversification

At first glance, it appears that there is a lot of diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. among these asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value.  The three primary asset classes used by many investors ... More, as the colored boxes move up and down on the chart from year to year.

The Reality

It wasn’t until I plotted the returns (using roughly the same colors) on a line chart that the true lack of diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. became apparent.

Even though the order of the indices changes, as shown in the Callan chart, most of them actually move substantially in sync.  For example, the MSCI Emerging Markets Index moves all over the Callan chart not because it adds diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. but because its returns are much more volatile.  In 14 of the 20 years in the Callan chart, the MSCI Emerging Markets Index is either at the top or the bottom.  It moves in the same direction as most of the other indices, it just makes bigger moves.

Correlations

The goal of adding new asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value.  The three primary asset classes used by many investors ... More to your portfolioA group of financial instruments. is to increase diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation..  Asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value.  The three primary asset classes used by many investors ... More are diversifying when they have negative or even small positive correlationA number between -100% and +100% that represents the extent to which two processes or variables move in the same direction at the same time..  I provide a detailed explanation of correlationA number between -100% and +100% that represents the extent to which two processes or variables move in the same direction at the same time. and diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. in this post.  The chart below shows the correlations between each pair of indices in the Callan chart.

High positive correlations are highlighted in red (as that means they aren’t diversifying).  Medium positive correlations are shown in yellow and small positive and negative correlations (the ones we are seeking) are in green.

It becomes quickly apparent that the only asset classA group of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors a... More that is diversifying over this time period is US bonds (Bloomberg Barclays (BB) Aggregate US BondA form of debt issued by government entities and corporations. Index).  If you look at the line graph above, I have made the line for the Bloomberg Barclays Aggregate US BondA form of debt issued by government entities and corporations. Index a bit thicker than the others to help you see its lack of correlationA number between -100% and +100% that represents the extent to which two processes or variables move in the same direction at the same time. with the other investment classes.

Different Insights

While I found the diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. message misleading in this chart, I still found value in the data itself.

Investment-Grade Bonds add Diversification

First, as discussed above, the diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. benefit of investment-grade bonds relative to all of the stock indices is quite evident.  Interestingly, high-yield bonds are highly correlated with stocks, so don’t add diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation..

Asset Classes Show Risk-Reward Balance

Second, I calculated the average annual return and the standard deviations of those returns.  As shown in the chart below, the different indices are spread widely along the spectrum that balances risk and reward.

Specifically, the Bloomberg Barclay Aggregate US BondA form of debt issued by government entities and corporations. Index is in the lower left corner indicating it has a lower average return than all of the other asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value.  The three primary asset classes used by many investors ... More over this time period but also has the lowest riskThe possibility that something bad will happen. as measured by the standard deviationA standard deviation is a (slightly messy) statistical calculation that results in a positive number that measures how much the possible results differ from the average result.  For those of you who ... More of the annual returns.  By comparison, the MSCI Emerging Markets Index has both the highest annual average return and the highest riskThe possibility that something bad will happen., as it is in the upper right corner of the chart.  All of the other indices fall in the middle on both average return and riskThe possibility that something bad will happen..

Selecting Asset Classes for Your Portfolio

As you are choosing the asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value.  The three primary asset classes used by many investors ... More in which you want to invest, you need to consider all three of average annual return, riskThe possibility that something bad will happen. and diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. benefits.  For example, if you have a very long time horizon and can tolerate the ups and downs of the returns, the historical data indicates that investing primarily in the Emerging Markets index would maximize your return.

If you have a shorter time horizon or are less able to watch the value of your investments go up and down, you might want to invest in something with a lower return, such as one of the stock indices.  If you have even lower risk tolerancePersonal preference indicating how much risk you are willing to take to achieve a higher return. or a shorter time horizon, you might want to add something like the Aggregate US BondA form of debt issued by government entities and corporations. Index to your portfolioA group of financial instruments..  It is important to recognize, though, that adding the less volatile asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value.  The three primary asset classes used by many investors ... More to your portfolioA group of financial instruments., even if they are diversifying, will lower the expected annual return on your portfolioA group of financial instruments. at the same time it is lowering your riskThe possibility that something bad will happen..

Caution about Using Past Findings in the Future

In closing, I caution you that the time period covered by the Callan charts corresponds to a time period during which interestA charge for borrowing money, most often based on a percentage of the amount owed. rates were relatively low and generally decreasing.  During the time period from 1997 to 2017, the highest yield on the 10-year US Treasury on a year-ending date was 6.7% at the end of 1999.    It decreased to 1.7% at the end of 2014 and increased very slightly to 2.7% by the end of 2017.  By comparison, it hit a high of 12.7% at the end of 1981 and is currently (August 2020) below 1%.  Neither extreme is covered by this time period.

The relatively stable returns on the Bloomberg Barclay Aggregate US BondA form of debt issued by government entities and corporations. Fund Index may be more representative of the time period included in the analysis and may understate the overall volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. of that index over a longer period of time.  Similarly, the other indices may behave differently in other interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More environments.

I suggest using the information in this post to enhance your understanding of the returns, volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. and diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. benefit of the different asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value.  The three primary asset classes used by many investors ... More.  You’ll want to supplement this information with your views on future economic environments before making any investment decisions.

[1] I am not able to include the chart directly in this post as I am not willing to accept the conditions that would be required by Schwab to get its permission.

[2] As measured by the S&P 500.

[3] As measured by the iShares 20+ Year Treasury BondA bond issued by the US government with a fixed interest rate and a maturity of more than 10 years. Fund ETF starting in 2002 and my approximation of those returns for prior years.  I note that the Schwab chart uses the Bloomberg Barclays U.S. Aggregate BondA form of debt issued by government entities and corporations. Index for bonds and the FTSE Treasury BillA bond issued by the US government with a fixed interest rate and a maturity of less than one year 3 Month Index for cash.  I don’t not have access to that information.  Because I used a government bondA form of debt issued by government entities and corporations. index that tends to provide lower returns than a corporate bondA form of debt issued by government entities and corporations. index, I used 40% weight to bonds and ignored the cash component.

[4] Used with permission.  https://www.callan.com/?s=2017+Periodic+Table.  August 8, 2020.