Diversification Results in Steady Returns - Statistical Data Included

Healthcare Financial Management, Dec, 1999 by William G. Kistner

To protect their return on investment over the long term, investors should diversify their portfolio holdings. Diversification protects a portfolio from major losses when any one asset class drops in value. Asset classes change in value over time but at widely varying rates. Therefore, diversification can reduce a portfolio's overall risk because an investor is less likely to sell shares in an asset class when the price drops. To diversify correctly investors need to plan carefully and understand their own risk tolerance and goals.

Spread Risk

How investors allocate assets among large-cap and small-cap stocks, bonds, international stocks, real estate, and money market funds will depend upon their age, goals, and risk tolerance. Although investments in some asset classes have had high returns over the past few years, trends usually reverse themselves over time. For example, a 1989 portfolio that consisted only of Japanese equities, the hottest investment of the day, today would be worth only 59 percent of its original value. But if the portfolio had included investments in international stocks and domestic and foreign bonds, the results would have been far better.

Diversification may appear unappealing when investors look at the poor returns in some formerly high-performing asset classes. International stocks, for instance, once had a long-term track record that was far superior to U.S. stocks, but this is no longer true. In fact, the S&P 500's fabulous performance in recent years has allowed it to draw ahead of the international benchmark index. From 1970 to 1998, the S&P 500 gained an average 13.48 percent per year, while the Morgan Stanley Capital International (MSCI) EAFE index of foreign stocks rose an average of 12.75 percent per year.

Most financial advisers recommend that a portfolio include up to 20 percent of international funds. Foreign stocks had been prized not only for performance, but also because their movements were largely uncorrelated with those of U.S. stocks. Presumably because of the rise of globalization, however, that correlation has increased substantially Of course, foreign stocks do not move in lockstep with U.S. equities. The Lipper mutual fund indexes for January 1, 1999, through June 1, 1999, show that U.S. growth funds were up 5.08 percent, but emerging market funds were the top performers, with a gain of 23.22 percent.

After the disappointing performance of emerging market equities over the past five years, some advisers no longer recommend emerging market stocks as an asset class. Investors may want to do the same, although they should realize that, by this logic, large-cap U.S. stocks would have ceased to be an asset class after 1932. Between 1928 and 1932, the annualized return for the S&P 500 was an abysmal -- 12.74 percent. One approach investors can adopt is to select an international fund that has some emerging market exposure.

Rebalance

Investors should rebalance their asset allocation periodically to ensure that their portfolio continues to meet their diversification goals. Rebalancing ensures that an investor will buy low and sell high, even if tempted to do the opposite.

The asset allocation of a $100,000 portfolio in 1994 would look very different today (see Exhibit 1) because the superior performance of large-cap stocks has radically changed the portfolio mix. Although the original investment has more than doubled to $200,335, for an annualized return of almost 14.91 percent, the investor should take steps to bring the asset allocation back in line with his or her diversification goals. To rebalance, the investor would sell one-third of the large-cap holdings and redistribute the proceeds among the other four asset classes to return to the original asset allocation.

Perhaps the best way to rebalance is to make the process as automatic as possible, by doing it on the same day every year, for example. Or the investor may choose to rebalance sooner if a significant market move dramatically changes the asset allocation. Attempts at market timing, however, almost invariably diminish returns, as many studies have shown. Research also has shown that those who buy and sell sector funds (such as technology or energy funds) for short-term gains usually do less well than investors who do not try to time the market but instead invest for the long term. Typically, short-term investors buy equities in a sector after it already has begun to outperform (they do not buy low), and they sell well after it has peaked (they do not sell high).

Rebalancing the allocation of assets in a tax-deferred account, such as an IRA, Keogh, or 401(k), has no tax consequences. Rebalancing in a taxable account, however, could result in tax consequences. One way to rebalance without increasing the amount of tax owed is by making new investments in the asset classes that compose a smaller percentage of the total allocation.

Avoid Duplication

Many investors think they are more diversified than they really are. A portfolio that consists only of six different large-cap growth funds is not diversified. Most likely, there will be considerable duplication in the stocks that these funds hold. If growth stocks drop in value, all six funds probably will lose value.