A Financial Literacy Blog for All
Many people view residential rental property as a great investment. I’ve never had any interestA charge for borrowing money, most often based on a percentage of the amount owed. More in committing the time I perceive is necessary. I’ve also not made much money on …
DiversificationThe reduction in volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. More created by combining two or more processes (such as the prices of financial instruments) that do not have 100% 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. More. More is an important component of any investing plan. It assists you in limiting your riskThe possibility that something bad will …
Investment diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More is an important tool that many investors used to reduce riskThe possibility that something bad will happen. More. Last week, I explained diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More and how it is related to 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. More. In this post, I’ll illustrate different ways you can use investment diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More and provide illustrations of its benefits.
Here are some key take-aways about investment diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More.
I’ll explain these points in more detail in the rest of the post.
The purpose 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. More is to reduce riskThe possibility that something bad will happen. More. It has no impact on return. The total return of any combination of financial instruments will always be 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 on the individual financial instruments, where the weights are the amounts of each instrument you own. For example, if you own $3,000 of a financial instrumentAny investment that you purchase. Examples include an exchange-traded fund, a mutual fund, stock in an individual company, a bond and a money market fund. There are also many more complex financia... More with a return of 5% and $7,000 of a different financial instrumentAny investment that you purchase. Examples include an exchange-traded fund, a mutual fund, stock in an individual company, a bond and a money market fund. There are also many more complex financia... More with a return of 15%, your total return will be 12% (={$3,000 x 5% + $7,000 x 15%}/{$3,000+$7,000} = {$150 + $1,050}/$10,000 = $1,200/$10,000). Similarly, two instruments that both return 10% will have a combined return of 10% regardless of how correlated they are, even -100% 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. More.
When investing, many people diversify their portfolios by investing in 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. The most common of these approaches is to allocate part of their portfolioA group of financial instruments. More to stocks or equity mutual funds and part to bonds or bondA form of debt issued by government entities and corporations. More mutual funds. These allocation approaches require that the portfolio be re-balanced on a regular basis to maintain the target asset allocation.
Two very common 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 for personal investment are bonds and stocks. Click here to learn more about bonds, including a comparison between stocks and bonds. Click here to learn more about stocks.
The prices of stocks and bonds sometimes move in the same direction and sometimes move in opposite directions. In good economies, companies make a lot of money and interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates are often low. When companies make money, their stock prices tend to increase. When interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates are low, bondA form of debt issued by government entities and corporations. More prices are high.[1] So, in good economies, we often see stock and bondA form of debt issued by government entities and corporations. More prices move in the same direction.
However, from 1977 through 1981, bondA form of debt issued by government entities and corporations. More prices went down while stocks went up. At the time, the economy was coming out of a recession (which means stock prices started out low and then rose), but inflation increased. When inflation increases, interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates tend to also increase and bondA form of debt issued by government entities and corporations. More prices go down. [2]
Over the past 40 years, interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates have generally decreased (meaning bondA form of debt issued by government entities and corporations. More prices went up) and stock markets increased in more years than not, as shown in the graph below.
The blue line shows the amount of money you would have each year if you invested $100 in the S&P 500 in 1980. The green line shows the 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 on the 10-year US treasury noteA bond issued by the US government with a fixed interest rate and a maturity of one to 10 years More, with the scale being on the right side of the graph. Because bondA form of debt issued by government entities and corporations. More prices go up when interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates go down, we anticipate that there will be 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. More between stock and bondA form of debt issued by government entities and corporations. More prices over this period. If we looked at a longer time period, the 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. More would still be positive, but not quite as high because, as mentioned above, there were periods when bondA form of debt issued by government entities and corporations. More prices went down and stock prices increased.
I will use annual returns on the S&P 500 and the Fidelity Investment Grade BondA form of debt issued by government entities and corporations. More Fund to illustrate the 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. More between stocks and bonds. The graph below is a scatter plot of the annual returns on these two financial instruments from 1980 through 2018. The returns on the bondA form of debt issued by government entities and corporations. More fund are shown on the x axis; the returns on the S&P 500, the y axis. Over this time period, the 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. More between the returns on these two financial instruments is 43%. This 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. More is close to the +50% 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. More illustrated in one of the scatter plots in last week’s post. Not surprisingly, this graph looks somewhat similar to the +50% 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. More graph in that post.
Recall that diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More is the reduction of riskThe possibility that something bad will happen. More, in this case, by owning both stocks and bonds. The table below sets the baseline from which I will measure 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. More benefit. It summarizes the average returns and standard deviations of the annual returns on the S&P 500 (a measure of stock returns) and a bondA form of debt issued by government entities and corporations. More fund (an approximation of bondA form of debt issued by government entities and corporations. More returns) from 1980 to 2018. The bondA form of debt issued by government entities and corporations. More fund has a lower return and less volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. More, as shown by the lower average and 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, than the S&P 500.
| BondA form of debt issued by government entities and corporations. More Fund | S&P 500 | |
| Average | 0.6% | 0.8% |
| 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 | 1.6% | 4.3% |
The graph below is a box & whisker plot showing the volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. More of each of these financial instruments separately (the boxes on the far left and far right) and portfolios containing different combinations of them. (See my post on risk for an explanation of how to read this chart.)
In this graph, the boxes represent the 25th to the 75th percentiles. The whiskers correspond to the 5th to 95th percentiles. As the portfolios have increasing amounts of stocks, the total return and volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. More increase.
These results can also be shown on a scatter plot, as shown in the graph below. In this case, the x or horizontal axis shows the average return for each portfolioA group of financial instruments. More. The y or vertical axis shows the percentage of the time that the return was negative. (See my post on making financial decisions for an explanation of optimal choices.)
There are three pairs of portfolios that have the same percentage of years with a negative return, but the one with more stocks in each pair has a higher return. For example, about 24% of the time the portfolios with 30% and 50% invested in bonds had negative returns. The 30% bondA form of debt issued by government entities and corporations. More portfolioA group of financial instruments. More returned 8.9% on average, whereas the 50% bondA form of debt issued by government entities and corporations. More portfolioA group of financial instruments. More returned 8.5% on average. Therefore, the portfolioA group of financial instruments. More with 30% bonds is preferred over the one with 50% bonds using these metrics because it has the same probabilityA percentage or the equivalent fraction that falls between 0% and 100% (i.e., between 0 and 1) that represents the ratio of the number of times that the outcome meets some criteria to the number of po... More of a negative return but a higher average return.
The choice of mix between stocks and bonds depends on how much return you need to earn to meet your financial goals and how much volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. More you are willing to tolerate. A goal of maximizing return without regard to riskThe possibility that something bad will happen. More is consistent with one of the portfolios with no bonds or only a very small percentage of them. At the other extreme, a portfolioA group of financial instruments. More with a high percentage (possibly as much as 100%) of bonds is consistent with a goal of minimizing the chance of losing money in any one year. The options in the middle are consistent with objectives that combine attaining a higher return and reducing riskThe possibility that something bad will happen. More.
Another approach is to use one of the asset allocations advocated by others. There is the three-fund portfolio, the four-fund portfolio, the Swensen portfolio and the All Seasons portfolio, among others.
There are many 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 that can be used for investment diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More. Some people prefer tangible assetsThe value of things the company owns and amounts it is owed More, such as gold, real estate, mineral rights (including oil and gas) or fine art, while others use a wider variety of financial instruments, such as options or futures. When considering tangible assetsThe value of things the company owns and amounts it is owed More, it is important to consider not only the possible appreciation in value but also the costs of owning them which can significantly reduce your total return. Examples of costs of ownership include storage for gold and maintenance, insurance and property taxes for real estate. All of the alternate investments I’ve mentioned, other than gold, also require expertise to increase the likelihood of getting appreciation from your investment. Not everyone can identify the next Picasso!
One of the most common applications 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. More is to invest in more than one company’s stock. It is even better if the companies are spread across different industries. The greatest benefit from diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More is gained by investing in companies with low or negative 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. More. Common factors often drive the stock price changes for companies within a single industry, so they tend to show fairly high 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. More.
DiversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More across industries is so important that Jim Cramer has a segment on his show, Mad Money, called “Am I Diversified?” In it, callers tell him the five companies in which they own the most stock and he tells them whether they are diversified based on the industries in which the companies fall.
To illustrate 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. More across companies, I have chosen five companies that are part of the Dow Jones Industrial AverageAn index commonly used to measure stock market performance composed of 30 very large companies. More (an index commonly used to measure stock market performance composed of 30 very large companies). These companies and their industries are:
| American Express (AXP) | Financial Services |
| Apple (AAPL) | Technology |
| Boeing (BA) | Industrial |
| Disney (DIS) | Consumer Discretionary |
| Home Depot (HD) | Consumer Staples |
The graph below shows the correlations in the annual prices changes across these companies.
The highest correlations are between American Express and each of Boeing and Disney (both between 50% and 55%). The lowest 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. More is between Apple and Boeing (about 10%).
The graph below shows a box & whisker plot of the annual returns of these companies’ stocks.
All of the companies have about a 25% chance (the bottom of the box) of having a negative return in one year. That is, if you owned any one of these stocks for one calendar year between 1983 and 2018, you had a 25% chance that you would have lost money on your investment.
The graph below shows a box & whisker chart showing how your volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. More and riskThe possibility that something bad will happen. More would have been reduced if you had owned just Apple and then added equal amounts of the other stocks successively until, in the far-right box, you owned all five stocks.
The distance between the tops and bottoms of the whiskers get smaller as each stock is added to the mix. If you had owned equal amounts of all five stocks for any one calendar year in this time period, you would have lost money in 19% of the years instead of 25%. The 25th percentileThe value below which a stated percent of observations fall. For example, 25% of the observations fall below the value corresponding to the 25thpercentile. More (bottom of the box) increases from between -5% and 0% for each stock individually to +14% if you owned all five stocks. That is, 75% of the time, your return would have been greater than +14% if you had owned all 5 stocks.
As always, I remind you that past returns are not necessarily indicative of future returns. I used these five companies’ stocks for illustration and do not intend to imply that I recommend buying them (or not).
The above illustration makes investing look great! Wouldn’t it be nice if 75% of the time you could earn a return of at least 14% just by purchasing five stocks in different industries? That result was lucky on my part. I looked at the list of companies in the Dow Jones Industrial AverageAn index commonly used to measure stock market performance composed of 30 very large companies. More and picked the first five in alphabetical order that I thought were well known and in different industries. It turns out that, over the time period from 1983 through 2018, all of those stocks did very well. Their average annual returns ranged from 19% (Disney) to 40% (Apple). The Dow Jones Industrial AverageAn index commonly used to measure stock market performance composed of 30 very large companies. More, by comparison, had an average return of 10%. That means that most of the other stocks in the Average had a much lower return.
Being diversified won’t prevent losses, but it reduces them when one company experiences significant financial trouble or goes bankrupt. Here’s a recent example.
Pacific Gas and Electric (PG&E) is a California utility that conservative investors have bought for many, many years. I’ve added it to the box & whisker plot of the companies above in the graph below.
PG&E’s average return (10%) is lower than the other five stocks and about equal to the Dow Jones Industrial AverageAn index commonly used to measure stock market performance composed of 30 very large companies. More. Its volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. More is similar to Boeing and Disney as shown by the height of its box and spread of it whiskers being similar to those of the other two stocks.
However, on the day I am writing this post, PG&E declared bankruptcy. PG&E has been accused of starting a number of large wildfires in California as the result of allegedly poor maintenance of its power lines and insufficient trimming of trees near them. Here is a plot of its daily stock price over the past 12 months.
In the year ending January 26, 2019, PG&E’s stock price decreased by 72%. From its high in early November 2018 to its low in January 2019, it dropped by 87%.
Although diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More can’t completely protect you from such large losses, it can reduce their impact especially if you are invested in companies in different industries. If the only company in which you owned stock was PG&E, you would have lost 72% of your savings in one year. If, on the other hand, you had owned an equal amount of a second stock that performed the same as the Dow Jones Industrial AverageAn index commonly used to measure stock market performance composed of 30 very large companies. More over the same time period (-6%), you would have lost 39%. The graph below shows how much you would have lost for different numbers of other companies in your portfolioA group of financial instruments. More.
This graph shows how quickly the adverse impact of one stock can be offset by including other companies in a portfolioA group of financial instruments. More. In a portfolioA group of financial instruments. More of five stocks (PG&E and four others that performed the same as the Dow), the 72% loss is reduced to about a 20% loss. With 20 stocks, the loss is reduced to 10% (not much worse than the -6% for the Dow Jones Industrial AverageAn index commonly used to measure stock market performance composed of 30 very large companies. More).
Another way to benefit from diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. More is to own financial instruments for a long time. In all of the examples above, I illustrated the riskThe possibility that something bad will happen. More of holding financial instruments for one year at a time. Many financial instruments have ups and downs, but tend to generally follow an upward trend. The volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. More and riskThe possibility that something bad will happen. More of the average annual return of these instruments will decrease the longer they are held.
For illustration of 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. More benefit of time, I have used returns on the S&P 500. The graph below shows the volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. More of the average annual return on the S&P 500 for various time periods ranging from one to twenty years.
To create the “20 Years” box and whiskers in this graph, I started by identifying all 20-year periods starting from 1950 through the one starting in 1997. I calculated the average annual return for each 20-year period. I then determined the percentiles needed to create this graph. The values for the shorter time periods were calculated in the same manner.
The average return over all years is about 8.8%. Because we are using data from 1950 to 2018 for all of these calculations, the average doesn’t change.
The benefits of long-term investing are clear from this graph. There were no 20-year periods that had a negative return, whereas the one-year return was negative 25% of the time.
My post about whether Chris should pay off his mortgage provides a bit more complicated application of the same concepts. In that case, Chris puts money into the account for five years and then withdraws it for either the next five years or the next 21 years. The longer he invests, the more likely he is to be better off investing instead of paying off his mortgage.
As a reminder, it is important to remember that this concept applies well to financial measures such as mutual funds, exchange-traded funds and indexes. It also applies to the financial instruments of many companies, but not all. If a company starts a downward trend, especially if it is on the way to bankruptcy, it will show a negative return no matter how long you own it. If you choose to own stocks of individual companies, you will want to monitor their underlying financial performance (a topic for a future post) and news about them to minimize the chance that you continue to own them through a permanent downward trend.
[1]The price of a bondA form of debt issued by government entities and corporations. More is the present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More of the future interestA charge for borrowing money, most often based on a percentage of the amount owed. More and principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:
• Credit cards: The amount of purchases you have made but not paid on your credit card ... More payments using the 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 on the date the calculation is performed. That is, each payment is divided by (1+today’s 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)(time until payment is made). Because the denominator gets bigger as the 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 goes up, the present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More of each payment goes down. I’ll talk more about this in a future post on bonds.
[2]An explanation of the link between inflation and interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates is quite complicated. I’ll write about it at some point in the future. For now, I’ll just observe that they tend to increase at the same time.
Susie Q is a retired property-casualty actuaryA professional who assesses and manages the risks of financial investments, insurance policies and other potentially risky ventures. Source: www.investopedia.com/terms/a/actuary.asp More and mother of two adult children. As her children were moving from their teens into their 20s, she found she was frequently a resource on many, many financial decisions and she had insights and information she could provide to them on a wide array of financial decisions. She spent a significant portion of my career building statistical models of all of the financial risks of an insurance company and interpreting their findings to help senior management make better financial decisions. She is the primary author at Financial IQ by Susie Q and volunteers with other organizations related to financial education.
One of the key concepts used by many successful investors is diversificationThe reduction in volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. More created by combining two or more processes (such as the prices of financial instruments) that do not have 100% 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. More. More. In this post, I’ll define diversificationThe reduction in volatility …
Understanding financial riskThe possibility that something bad will happen. More is key to making sound decisions. Many people don’t have a good grasp on what riskThe possibility that something bad will happen. More means, particularly in a financial context, so I will focus this post …