I’m a big believer in well-diversified portfolios. Just how you define a well-diversified portfolio is a matter of opinion. You could own practically every stock in the global public markets and a pretty robust portfolio of bonds with three funds and investment expenses of about 0.15%. If you’re looking for a simple definition of diversification, “just own everything” is tough to beat.
If we look at history, is there a better way to build portfolios? And if so, when do you get the payout? In a year like 2014, it was tough to own anything but the simplest of portfolios. A 60% S&P 500, 40% Barclays Aggregate Bond beat out just about anything you can throw at it. Any allocation away from those assets hurt you. Add small caps? Lower returns. Add International? Lower returns. Add Emerging Markets? Lower returns. Add commodities (not that you should)? Lower returns. REITs actually helped, but they stood alone. Also if you tried to hedge your interest rate risk by owning short-term maturities you lost to the benchmark.
As a result, many investors probably gave up on being better diversified at the end of last year. Here’s Morningstar’s information on asset flows through year-end 2014. Net, almost 10x as much money went into US equity funds than went in to international funds, after US equity outperformed by almost 20% for the year. (As an aside – pretty wild data on active vs. passive fund flows here.)
If that meant throwing in the towel on international stocks and emerging markets, they’ve already begun to pay the price. But does it pay to own a more complex portfolio of multiple asset classes? And if so, when, and how often? I took a look.
To begin, I compared the annual performance of two portfolios. Our “simple” portfolio is made up of three benchmarks as below:
| Index | Allocation |
| Barclay’s US Aggregate Bond | 40.00% |
| S&P 500 | 30.00% |
| MSCI EAFE | 30.00% |
For comparison purposes only, here’s our complex portfolio. We’ll stick to our 60/40 split between stocks and bonds, but add a tilt to small caps and value, add REITs and split up the bond portfolio a bit:
| Index | Allocation |
| One-Month T-Bill | 10.00% |
| Five-Year T-Note | 10.00% |
| Long Term Gov Bonds | 20.00% |
| Fama/French US Large Value | 15.00% |
| Fama/French US Small Value | 10.00% |
| MSCI EAFE | 15.00% |
| DFA International Small Cap Index | 10.00% |
| DJ US REIT | 10.00% |
First, the long term numbers. From 1/1970 – 12/2014, the complex portfolio returned 11.48% (although REITs were not added until 1978 for lack of data) and the simple portfolio returned 10.96%, giving a modest edge to the complex portfolio over time. The complex portfolio had standard deviation of 9.35%, and the simple portfolio had 10.13%, again giving a slight edge to the complex portfolio. But in real time, the edge looks like this:
That’s the over/under for quarterly returns of the complex portfolio less the simple portfolio. The complex portfolio, despite having better nominal and risk-adjusted returns, only beats the simple portfolio 56% of the time. Barely over half. Sometimes the complex portfolio can lag behind (cumulatively) for years before catching back up. Almost half the time owners of the complex portfolio are going to regret it. The magnitude of outperformance in any given quarter is just about equal to the magnitude of possible underperformance. Here’s the same data re-sorted so you can see the full distribution:
Sometimes the more complex portfolio will pay off in a big way, and some times it will hurt in a big way. Historically it has paid off by a fair amount. I’m not telling you what you should be doing (although of course I have my opinions for client portfolios), but mostly I’m telling you to be prepared and understand what you own. A “better” portfolio design isn’t better all the time. What works in the long run doesn’t work every year. If you don’t understand that going in, if you think that your portfolio allocation choices will be superior to a simple portfolio or even the S&P 500 every year, you’re going to be disappointed. And that disappointment is probably going to lead you to making some poor, reactionary decisions with your investments.
Bason Asset Management 