Seeing Diversification in Action

Why should you add multiple asset classes to your portfolio? That seems like a simple question, but it’s one many investors would answer with only a vague comment about “more diversification.” It’s more precise to say you do so to increase expected returns or to decrease volatility. Sometimes these are mutually exclusive, but Harry Markowitz won a Nobel Prize for explaining that you can sometimes accomplish both at the same time. That insight is the basis for Modern Portfolio Theory.

One of the clearest illustrations of this idea can be found in Larry Swedroe’s book Think, Act, and Invest Like Warren Buffett, which I reviewed late last year. Swedroe shows how the return and risk characteristics of a 60/40 portfolio change as you slice and dice the equity allocations.

A portfolio made up of just the S&P 500 and five-year Treasuries returned 10.6% annually from 1975 through 2011, with a standard deviation of 10.8%. By gradually splitting that equity allocation into multiple asset classes (international stocks, value stocks, small caps, and commodities) the portfolio’s annual return increased 150 basis points to 12.1%, while its volatility ticked up only 60 basis points to 11.2%.

It works in Canada, too

SwedroeHow would things look if you started with Canadian stocks and bonds and then added US and international equities, as well as small-caps and value stocks?

PWL Capital has collaborated with Swedroe to bring out a Canadian version of his book, which has a new title: Playing the Winner’s Game. The advice is the same, but the portfolio examples have been Canadianized. And it turns out the data illustrate Modern Portfolio Theory even more dramatically. Here are the numbers for five portfolios combining various equity asset classes with a 40% allocation to short-term bonds from 1980 through 2012:

Equity allocation Return Volatility
Portfolio A Canadian equities only 9.1% 11.1%
Portfolio B Add Canadian value 9.7% 11.2%
Portfolio C Add US and international 9.9% 9.4%
Portfolio D Add small caps 10.2% 9.4%
Portfolio E Add REITs 10.3% 8.7%

As you can see, in every case splicing the equity allocation increased returns and usually lowered volatility as well. As Swedroe explains, as we move from Portfolio A to E the return went up by 1.2 percentage points, which is a relative increase of 13%. Meanwhile, the standard deviation fell by 2.4 percentage points for a relative decrease of 22%. Higher returns, less risk—exactly what you should aim for when combining asset classes in a portfolio.

Cameron Passmore of PWL Capital’s Ottawa office, who co-wrote the foreword to Playing the Winner’s Game, has offered to send copies to five readers. Enter below for a chance to win.

Update: The book is not available in stores, but Cameron is offering to send a copy to anyone who makes a donation of at least $15 to the Welch Legacy Foundation, a charity he supports. Make your donation here and then email Cameron to let him know.

a Rafflecopter giveaway

32 Responses to Seeing Diversification in Action

  1. Gen Y July 24, 2013 at 10:25 am #

    That’s interesting, did the author mention the asset allocation changes as you combine asset classes?

  2. Canadian Couch Potato July 24, 2013 at 10:34 am #

    @Gen Y: Yes, there are more details in the book, including the specific indexes used and the asset allocation in each portfolio. For simplicity I didn’t want to repeat that here. If you’re interested in a similar illustration, check out Paul Merriman’s classic piece, which is updated every year:
    http://www.merriman.com/PDFs/UltimateBuyAndHold.pdf

  3. JW July 24, 2013 at 12:31 pm #

    Hey CCP, I read the Merriman article you suggested to Gen Y. I noticed that they recommend only government bonds whereas your Uber Tuber recommends Corporate. I favour your strategy over their’s but do you the back test results on the two strategies?

  4. Canadian Couch Potato July 24, 2013 at 12:45 pm #

    @JW: I haven’t got any backtests to share, but there are some advisors who suggest keeping all of the fixed income as safe as possible and taking any additional risk on the equity side. That’s a perfectly sound strategy, but it’s optional. I’m quite happy to have 20% to 30% of the bond portfolio in investment-grade corporate bonds (but not high-yield bonds), which is what you get with a broad-based bond fund like XBB, VAB, etc.

  5. Chris July 24, 2013 at 1:27 pm #

    That Merriman link is very misleading, to the point of being disingenuous. The name of the portfolio “Ultimate Buy and Hold” and the first 10 pages give the impression that they’re backtesting some kind of passive portfolio.

    If you read the fine print on the last page, it turns out that their backtest includes *nine* changes in asset allocation, including some that definitely juiced their returns (e.g., shifting into emerging markets in the mid-2000s as part of their “international” allocation). It’s essentially a tactical asset allocation backtest, which is why their results (11.5% annualized, once you add the 1% fee adjustment back in) appear to be significantly higher than passive investors with similar portfolios during the same period would likely have achieved.

  6. ken July 24, 2013 at 3:33 pm #

    I am a fan of Larry S and would love a copy!

  7. ccpfan July 24, 2013 at 4:06 pm #

    If I don’t win, is the book available somewhere? I looked for it on Amazon.ca, but I only found the US edition.

  8. Jesse Martyn July 24, 2013 at 6:09 pm #

    I’d love a copy so I could check over the results in more detail!

  9. The Other Paul G July 24, 2013 at 7:43 pm #

    Hey Dan, I follow each new post, seems like this could be a next step in my education on investing. I have 30/70 split bonds/equities so I’d be interested to know if this test hold true with different percentages of bonds (e.g. lower or higher). Is this also covered in the book?

    Paul G (but not the guy that usually posts under that pseudonym)

  10. Canadian Couch Potato July 24, 2013 at 8:56 pm #

    @Other Paul G: That’s a great question. In general, adding bonds to an equity portfolio will lower the volatility and the expected return. Thus is because stocks and bonds have very different risk-return profiles, whereas many equity asset classes do not. (For example, one should expect that over the very long term Canadian, US and international equities should have very similar returns and volatility.)

    That said, one of the key ideas in Modern Portfolio Theory is that adding a small amount of bonds to an equity portfolio can potentially lower volatility without changing expected returns by a significant amount, and vice-versa. You can’t know the proportions in advance, but 20% is a good estimate. In other words, a portfolio of 80% stocks and 20% bonds will be less volatile than 100% stocks, but its expected return is likely to be extremely similar. Same thing if you add 20% stocks to a bond portfolio. That’s why even the most aggressive investor should probably hold some bonds, and the most conservative investor would benefit from a small slice of stocks.

  11. Jerry July 24, 2013 at 11:14 pm #

    Here is a good link which quantifies allocations and returns:

    https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations

    I am getting near the end of full-time work and have decided to just go 50/50 until death do us part. I like simple math…..

  12. gsp July 25, 2013 at 12:57 am #

    @Chris, I think you are misunderstanding what Merriman is stating.

    Not sure where you see 9 AA changes and there’s no tactical AA involved. What you’re seeing is new indices/products being created over the years. There’s no shift to EM in the mid 2000s, the same 20% intl allocation is maintained, only difference is DFA launched DCFEX in mid 2005 so they started using it for EM.

    They very much are doing exactly what you initially thought they were: backtesting a passive portfolio.

    Backtesting comes with lots of issues and they try to warn readers about expecting similar results. One such issue is substracting current product expense ratios when using index data when fees would have been much higher at the time if such products had existed.

  13. Canadian Couch Potato July 25, 2013 at 2:03 am #

    @ccpfan: There’s no retail version of the book, but apparently an e-book is in the works.

  14. Chris July 25, 2013 at 9:32 am #

    @gsp: Look more closely at the data. For example, in 1998 Merriman’s backtest switched from a 30%/70% allocation in bonds to a 30%/50%/20% allocation in bonds (the 20% being TIPS). TIPS were available as an easily investible asset class long before 1998. Similarly, in 1982 they switch to a new allocation that strongly overweights small cap stocks (50% of the international portfolio) relative to their 1981 previous allocation (33% of the international portfolio). I can’t see any attempt to even approximate either (i) a passive, market-cap based weighting, or (ii) a consistent Fama-French style weighting.

    Even to the extent that they’re switching between various DFA funds as new ones became available, it’s no longer a passive portfolio; it’s subject to tactical decisions at DFA to launch new funds.

  15. Pat July 25, 2013 at 11:33 am #

    Hi Dan, the rate of return in the Merriman article is remarkable. I’d be interested in knowing what you think of the article. Is it misleading?
    The rate of return in the Canadian example is also remarkable. Is this definitely the way to go if your account is large enough?

  16. Pat July 25, 2013 at 1:29 pm #

    Is there an analyis available that compares this strategy to doing the same except that you buy the entire market for the equities portion?

  17. gsp July 25, 2013 at 1:50 pm #

    @Chris,
    “TIPS were available as an easily investible asset class long before 1998″

    TIPS were launched in January 1997, hence their inclusion starting in 1998. https://personal.vanguard.com/pdf/flgpt.pdf

    It’s unclear from the document what they used for intl SCV from ’82 to ’94. My guess is a new index was introduced at the time to track this asset class. If it interests you, just ask them.

    They prefer DFA funds whenever available. If switching to new products you think will better capture an asset class while maintaining your AA disqualifies investors from being passive in your eyes, very few will meet your threshold. Even CCP occasionally changes his model portfolios when better products are introduced.

    The fact remains this is not tactical asset allocation. Just an honest attempt to approximate returns using the best available products and indices over 43 years. As with all backtests, there are many issues and the returns are likely overestimated, especially in the early years.

    Merriman has a good rep and for good reason. Unfortunately many of the excellent articles and videos they previously provided on their websites have since been removed and are now only available to their customers. Founder Paul Merriman retired 2 years ago, perhaps that’s when the focus on investor education took a hit. It’s clearly a passion for him even in retirement.

  18. Canadian Couch Potato July 25, 2013 at 2:04 pm #

    I’m a bit concerned that some readers are getting hung up on the specifics here. The point of the illustration in Swedroe’s book wasn’t to leave you hoping for 10.3% returns. If nothing else, let’s remember that bond returns during the period considered (1980 to 2012) were much higher than the long-term average and almost certainly can’t be matched in the foreseeable future.

    The point was simply to demonstrate that combining risky assets with low correlation can actually lower volatility and increase returns. Maybe we take that for granted now, but it really should be a surprising finding. Using index data like this is just a way of showing rather than telling: it isn’t a promise of future returns.

  19. Chris July 25, 2013 at 3:17 pm #

    @gsp: “If switching to new products you think will better capture an asset class while maintaining your AA…”

    That’s simply not what they’re doing. They’re shifting their AA (asset allocation) over time. I don’t understand how you can argue otherwise from the fine print.

  20. Pat July 25, 2013 at 4:02 pm #

    Hi Dan, to clarify, my comments were about the differences in rates of return.

    However, I noticed the Merriman article uses the S&P500 as its starting point, which is not very diversified. A more meaningful starting point would use the total world equities market (or as close to it as you could get). Is there a similar analysis using the total world market as the starting point? That would be more helpful in deciding whether to use this strategy. What was included in the ‘Canadian equities only’ in Portfolio A of Swedroe’s Canadian book? Thanks

  21. gsp July 25, 2013 at 6:12 pm #

    @Chris, no ackowledgement that there was no EM AA shift in mid 2000s and that TIPS didn’t exist “long before 1998″?

    It’s quite simple to see what is going on with the AA. They are using their current recommended AA and fitting it to what was available over the period. They can’t use TIPS before ’98, REITS before ’72, etc as those asset classes did not exist. Does choosing your desired AA after the fact and retrofitting it inflate the returns? Absolutely. Merriman hadn’t even been founded for the first 14 years of this time period. Moreover, who knows what they were actually advising their customers to do over the last 30 years. To me these are all problems with backtested hypothetical returns as addressed in the first paragraph of their disclosure:

    “This document contains hypothetical results. The data is based on transactions that were not made. Instead, the trades were simulated, based on knowledge that was available only after the fact and thus with the benefit of hindsight. There are tremendous limitations inherent in the use of hypothetical results as portrayed here and you should not assume that your investments will perform similarly or that you will not lose money. We believe in the concepts presented here and use hypothetical data to educate investors. It should not be construed as actual performance nor should you expect your portfolio performance to replicate our hypothetical results.”

    IMO making a bunch of false claims(tactical AA, 9 AA changes, TIPS, EM shift) doesn’t add anything above the disclaimer.

  22. David July 25, 2013 at 7:46 pm #

    I believe that I have all of Larry’s earlier books. Started buying them 10 to 12 years ago.
    Well written, straight forward advice suitable for all levels of investors. Highly recommended.

  23. Canadian Couch Potato July 25, 2013 at 11:15 pm #

    @Pat: The point of the exercise is start with a single equity asset class and go from there. If you start with the entire global stock market how do you diversify further? Swedroe’s book starts with the S&P/TSX Composite Index for Canadian equities.

  24. Francis July 26, 2013 at 12:50 am #

    Did Swedroe’s use canadian small cap or US small cap?
    For reit did he use canadian, global or US?

  25. Pat July 26, 2013 at 6:13 am #

    Good point Dan. Let me rephrase my question. Is there an analysis available that shows how this strategy’s return and volatility compares to buying the whole equities market for the equities allocation?

  26. Canadian Couch Potato July 26, 2013 at 10:14 am #

    @Francis: Here are the indexes used in Portfolio E, which contained all the equity asset classes:

    S&P/TSX Composite
    Fama/French Canadian Value
    S&P 500
    Fama/French U.S. Large Value
    SBBI U.S. Small Cap
    MSCI EAFE
    MSCI EAFE Value
    DFA International Small Cap
    FTSE/NAREIT U.S. All REITs

    @Pat: OK, I understand your question now. I’m not aware of any analysis that compares these strategies specifically, but you could just track down returns for the MSCI World Index or something equivalent and use that as a benchmark.

  27. Francis July 28, 2013 at 3:46 pm #

    Wow that a really complicated portfolio to execute.

    If somebody manage himself this kind of portfolio, your post should have been title Why Your Problem Is Your Funds. If you need dimensional fund adviser to execute it you can kiss good bye to your edge for the return because you give away 1.5%.

    When you take time to analyse the difference in the portfolio, you realize that :

    -Canadian stock got lower return and higher volatility than all other stock asset.

    -Canadian value get more return for almost the same volatility.
    (On a side note, Does an index that track value stock got the same flaw than a fundamental index like RAFI you mention a post before index?)

    -US, US value, Int, Int value : give a better return for less volatity.
    (Probably explain by Canadian stock are poorly diversify compare to these index)

    -Adding small cap add little return and are very correlated to large stock (High chance that higher cost for this index will offset any gain in return.)

    -Adding US REIT will lower the volatility.
    (I have no quick explanation on this one but probably REIT been really bless the last 30 years to make about the same as US/Int stock with a lower volatility but I find REIT is a really small sector of the economy what happen if I would advise you to allocated a concentrated part of an other sector to your portfolio instead of REIT use a sector ETF like energy, communication, technology, healthcare,financial, commodity… I am guessing that I would be call a fool to over concentrate one sector like this. I bet could cherry pick a concentrated sector that done even better than REIT on the last 30 years)

    I am really no expert at all but what a take away in the end of the analyst of these number.
    -If you want higher return with lower volatility, don’t bother with Canadian stock because they lower your return and raise the volatility, just invest in US and international stock.

    -The value premium for Canadian is really hard to get through an index the only ETF for Can value that I know that is accessible to everyone is FXM but that an alternate index and don’t know if they use a similar methodology than a value vanguard ETF for US stock, so count me out for this class asset.

    -It hard to determine what was the add return and volatility for US and International value stock since everything seem to be blend in portfolio C but value index cost a lot more so they are cursed to beat the broadband market index like the RAFI index.

    -Small cap index add little return cost a lot more and seem to be highly correlated because they don’t lower the volatility of higher caps so why bother.

    -If you feel lucky add a concentration in a sector of the US market and hope for the best in 30 years but remember past return don’t guarantee future return.

    -So the best simple portfolio with a high likelihood to get the same result of portfolio E could be in the end as simple as 20%US, 20%Int, 10%US value, 10% Int Value, 40% bond but I am pretty sure you could put the value out and get pretty similar result.

    I read the book it All About Asset Allocation with all these crazy portfolio idea with 15 moving part that you need to re balance to get a maybe 0.8% return more if you do everything right. I use to think Andrew Hallam was the crazy one with his 3 ETFs for $2 million worth of portfolio but now I think he is the smart one. In the end, like a read in the All About Asset Allocation book 80% of your return is your exposure to stock compare to bond. The other 20% I begin to think is just pure luck.

  28. Canadian Couch Potato July 28, 2013 at 6:16 pm #

    @Francis: Yes, a portfolio with all of those asset classes would certainly be difficult to manage, and I wouldn’t recommend it for the DIYer. But, for the record, it is possible for an advisor to build something similar with a combination of ETFs and DFA funds for less than 40 basis points. (That’s MER only and not the advisor’s fee, but the advisor’s fee is not there to add alpha: its for planning and portfolio management).

    RE: “I used to think Andrew Hallam was the crazy one with his 3 ETFs for $2 million worth of portfolio but now I think he is the smart one.” Absolutely.

  29. Rahim July 30, 2013 at 6:03 pm #

    Hi CCP,

    Thanks for the breakdown. Unfortunately I don’t have many options to diversify with RBC (I currently have a small portfolio of mutual index funds). They only offer 4 fund classes: Cdn equity index, US equity index, Int’l equity index, and Cdn Gov’t bond index. While this probably provides enough diversification for small portfolios, I hope that they eventually add REIT and small-cap mutual index funds when my portfolio gets a bit bigger. Do you think the big banks like RBC, TD, and CIBC will eventually add these type of index funds to their offerings?

  30. Canadian Couch Potato July 30, 2013 at 8:10 pm #

    @Rahim: Unfortunately, I don’t expect the banks to expand their index fund offerings. There really is no profit in it for them, and while indexing is growing in popularity, new investors prefer ETFs. Once your portfolio is big enough to warrant more diversification it is probably worth opening a discount brokerage account and using ETFs.

  31. Jean Vaucher August 1, 2013 at 11:56 pm #

    I enjoyed that last few postings and got the point: Diversify and use EFTs or Index Funds…. But the results underline an important point: even with the best strategy, some years you will lose money. Cited results show that good 60/40 portfolios give (roughly) 10% returns with a 10% standard deviation. Given a bell-shaped distribution, that means that 16% of the time ( 1 year out of 6), returns will be negative.

    Of course, losses are balanced by returns of 20% or more 1 year out of 6; but I conclude that one should have enough cash around to survive those lean years without dipping into investments.

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