Deep Thoughts on Diversification

Just shy of two years ago—in October 2011—I wrote a post that laid out the year-to-date returns for the Complete Couch Potato portfolio. If you can remember that far back, the third quarter of 2011 was truly ugly. The European debt crisis was all over the news, the US government’s credit rating was downgraded, and the global economic outlook was bleak. If you held a diversified portfolio, your equities were in the toilet, but you were saved by a solid performance from REITs and outstanding returns from bonds, especially real-return bonds. Overall, the portfolio experienced a small loss over the first nine months of the year:

January–September 2011 Ticker  % Return
iShares S&P/TSX Composite XIC 20% -12.02%
Vanguard Total Stock Market VTI 15% -5.26%
Vanguard Total Int’l Stock Market VXUS 15% -13.82%
BMO Equal Weight REITs ZRE 10% 5.77%
 iShares DEX Real-Return Bond XRB 10% 9.53%
 iShares DEX Universe Bond XBB 30% 7.20%
Total -1.6%

Now let’s look at how the Couch Potato has performed so far in 2013. Here are the returns as of August 30:

January–August 2013 Ticker  % YTD return
iShares S&P/TSX Composite XIC 20% 3.2%
Vanguard Total Stock Market VTI 15% 20.8%
Vanguard Total Int’l Stock Market VXUS 15% 5.6%
BMO Equal Weight REITs ZRE 10% -10.5%
 iShares DEX Real-Return Bond XRB 10% -10.5%
 iShares DEX Universe Bond XBB 30% -2.1%
Total 1.9%

How’s that for an about-face? So far this year, equities are in the black, with the US leading the way with both a strong stock market and a rising currency. Meanwhile, REITs and bonds (especially real-return bonds) have been throttled by rising interest rates and are on track for a negative year. However, the portfolio as whole has enjoyed a modest gain so far this year.

The rest of the story

The smart-asses in the audience will look at these two periods and scoff that “you Couch Potatoes didn’t make any money.” But we haven’t accounted for the 15 months between these two samples—that is, October 2011 through December 2012. As it happens, equity markets rebounded shortly after I wrote that original post: 2011 finished with a modest 2.4% return for the Complete Couch Potato. And 2012 was a strong year for all asset classes, with the portfolio logging a solid 8.7%.

So if we take a longer view—and we are long-term investors, after all—the numbers look like this for the full 32 months. These returns are annualized, and they assume the portfolio was rebalanced on January 1 of both 2012 and 2013:

January 2011-August 2013 Ticker  % Return
iShares S&P/TSX Composite XIC 20% 0.6%
Vanguard Total Stock Market VTI 15% 19.0%
Vanguard Total Int’l Stock Market VXUS 15% 5.9%
BMO Equal Weight REITs ZRE 10% 6.7%
 iShares DEX Real-Return Bond XRB 10% 2.8%
 iShares DEX Universe Bond XBB 30% 3.8%
Total (annualized) 5.9%

Sandwiched between two difficult periods was a long stretch where both stocks and bonds performed well. Ironically, that was when you probably felt best about holding a diversified portfolio. I say ironically because when all asset classes perform well, diversification isn’t all that important. After all, it would have been hard to lose money in 2012, even if you made a few dumb moves at the wrong time.

On the other hand, in 2011 and 2013, you probably questioned the whole idea of a multi-asset-class portfolio. During the European crisis holding 15% in international equities felt like fiddling while Rome (and Lisbon and Athens) burned. And today we’re wondering why we didn’t listen to the bond bears who have been growling for years.

Yet these were precisely the periods when you most needed diversification. It saved you from significant losses both times. It allowed to you avoid ill-timed tactical shifts that would have slaughtered your returns. And it kept you fully invested so you were able to reap all the rewards of late 2011 and 2012.

An investor’s prayer

And so my children, bow your heads and as we reflect on the virtues of diversification. I invite you to carry these verses in your wallet and read them during those difficult times of market turmoil.

Footprints On My Portfolio

  One night I had a dream—
I dreamed I held a diversified portfolio
and across my spreadsheet flashed scenes from my investing life.
For each scene I noticed two sets of footprints:
one belonged to stocks and the other to bonds.

When the last scene flashed before me,
I looked at the graph of my portfolio’s performance.
I noticed that many times during my investing journey,
there was only one set of footprints.
I also noticed that this happened during the
most difficult bear markets.

This really bothered me and I questioned my advisor about it.
“You said that once I decided to diversify,
it would benefit me all the time.
But I have noticed that during the most difficult markets
there is only one set of footprints.
I don’t understand why in times when I needed it most,
diversification should leave me.”

Mt advisor replied, “My precious, precious client,
Diversification did not leave you
during those difficult periods.
When you saw only one set of footprints,
it was then that it carried you.”

42 Responses to Deep Thoughts on Diversification

  1. David September 3, 2013 at 2:09 pm #

    Very happy with my e-series Couch Potato portfolio, thank you very much.

  2. Waheed September 3, 2013 at 3:41 pm #

    Is it possible to include the TD e-series Index Fund version of the Global Couch Potato in your next summary? Thanks!

  3. Be'en September 3, 2013 at 5:16 pm #

    Investor’s prayer: “precious”, my precious! 🙂

  4. Canadian Dividend Blogger September 3, 2013 at 10:32 pm #

    My gut feel about balanced couch potato type portfolios, and why they produce decent long term returns, is that they are a means of rebalancing into equities during ideal buying opportunities; sort of an automatic market timing mechanism. Bonds do not provide much real return but tend to balance out inflation; then when stock markets crash, these automatic rebalancers pick up shares in companies (through indexes or funds or whatever) by either new cash or selling bonds; providing, of course, they do not run screaming and sell everything (like many people did in 2008-09). This rebalancing into equities is where the real wealth creation happens, especially when it is into battered markets.

    There hasn’t been a real crash in 5 years now. I wonder how most people will hold up in the next one. History suggests we’ll see one sooner rather than later.

  5. abraxas September 4, 2013 at 9:33 am #

    Diversification is all good and well but the central banks’ QInfinity appears to have significantly increased stocks and bonds correlations. I think the types of asset classes in the model portfolios on this website are insufficient to cushion any downside risk going forward. Simple scenario: QE ends or the bond market starts asking for a decent risk premium again: bonds collapse because of rising yields and at the same time stocks fall in sympathy because the risk free rate or return has shot up and stocks must adjust on the downside. With QE in place, stocks are just a high beta play on interest rates.

  6. Canadian Couch Potato September 4, 2013 at 9:42 am #

    @abraxas: Do you have any data to support your claim that the correlation between stocks and bonds has increased? It’s fine to spin a narrative, but without data to back it up, it’s just more market noise that should be ignored by long-term investors.

    For the record, a recent Vanguard paper looked at the correlations between equities and several other asset classes from 1988 through 2012. According to their data, “U.S. investment-grade bonds and international bonds have been a reliable cushion to equity market volatility when investors value a cushion most—that is, during sharp stock declines. On average, many of the other asset classes have had low correlations with equities, but their long-term averages have masked a relatively high correlation with stocks during short periods of market distress.”

    The paper can be found here: https://advisors.vanguard.com/VGApp/iip/site/advisor/researchcommentary/article/IWE_InvResReducingBonds

  7. abraxas September 4, 2013 at 9:59 am #

    Anyone payin attention to the markets can see the positive correlation developing. But if you want a pretty graph, look here:

    http://s.wsj.net/public/resources/images/OB-YI021_correl_P_20130725112322.jpg

  8. Canadian Couch Potato September 4, 2013 at 10:15 am #

    @abraxas: The graph you linked to actually contradicts your argument. You write that “Anyone can see the positive correlation developing.” But the graph shows correlations between bond yields and stocks are now at the lowest they have been since 2008. And indeed, rising rates have driven bond prices down sharply this year, while US stocks are up sharply. That’s negative correlation defined.

  9. abraxas September 4, 2013 at 10:58 am #

    Quite the opposite. The graph shows interest rate changes not bond prices. This means that a spike in interest rates (and resultant fall in bonds) is not offest by rising stock prices.

  10. Canadian Couch Potato September 4, 2013 at 11:12 am #

    @abraxas: The fall in bond prices this year has been more than offset by rising stock prices. That’s the whole point of the original post. And in 2011, when equities were pummeled, it was the exact opposite. In 2008, bonds also went up sharply up when stocks went down. You’re welcome to spin that story anyway you want, but that is negative correlation, and it’s exactly what investors expect from a diversified portfolio.

  11. Kiyo September 4, 2013 at 1:07 pm #

    I might add that no-one should really care about the 3 month correlation except day traders. The correlation calculated over 3 months gets its ‘power’ from time scales as short as a day and as long 3 months, in roughly equal parts. Long term investors care about market movements on time scales *longer* than three months. So what you should do is smooth the data with something like a 3 month moving average (to get rid of all the short time scale stuff), then calculate the correlation over several years.

    That dip you are seeing at the end of the graph is coming from a single interest rate movement… the one we just experienced from May to August. The S&P500 saw most of its returns from December to May. On less than three month time scales they correlate very poorly. On long time scales, they are doing their job nicely.

  12. Kdawg September 4, 2013 at 3:15 pm #

    Fantastic blog and interesting post. I’m a fairly new investor and in the process of switching to a passive investment strategy based largely on what I have read on this site in the past weeks and months. I’m early 30s and in the process of aggressively paying down my mortgage. Does it make sense to consider that as my fixed income/bond portion of a couch potato model portfolio? Obviously, it wouldn’t have the return your bond mix did in 2011 in offsetting equitities in a down market, but I’m generally fine with a slightly lower, albeit guaranteed return in the short-term. I figure I’ll have the mortgage paid off in 3-4 years if I keep hammering at it and then could rebalance with your suggested bond ETFs at that time. Thanks, and I apologize if this question is a retread from elsewhere on the site.

  13. Canadian Couch Potato September 4, 2013 at 3:25 pm #

    @Kdawg: Welcome to the blog. Paying off your mortgage rather than investing may be a great strategy, but it doesn’t really have anything to do with the asset allocation decision. It might be different if you were the lender and you were receiving bond-like interest payments. But as the borrower, your mortgage is on the opposite side of the balance sheet. So your first decision is “invest or pay down the mortgage?” and if you decide to invest, you can then think about your stock/bond mix.

  14. Mother September 4, 2013 at 3:45 pm #

    Just wanted to say that I have a good chunk of my small retirement fund and savings in the complete couch potato, and have done so for a couple years. So thanks for your work, and I’m trying to pay attention to everything you are blogging about. 🙂

  15. Kdawg September 4, 2013 at 4:48 pm #

    Thanks, CCP. My focus is paying off the mortgage, but I also have a generous matching program from my employer that goes into my RRSP that has gotten to a size where I need to be smarter about what I am doing with it. Hence, my interest in your blog and investment strategy, and my need to reconcile both sides of the equation. I realize that equating the payment of a mortgage (a “return” through eliminating known future interest payment) with the receipt of bond-like interest is an artificial and, perhaps, imprudent construct, but my simplistic view of it was that I was getting a guaranteed return from that mortage payment (which seems somewhat bondlike to me) and I was concerned about under exposing myself to equities if I also included bonds in my RRSP portfolio. Sorry if I’ve now given you a headache.

  16. Canadian Couch Potato September 4, 2013 at 4:58 pm #

    @Kdawg: No headache at all. 🙂 The logic makes sense on the surface, but it’s not the best way to asses the amount of risk to take in your RRSP. Good luck and don’t hesitate to ask other questions.

  17. Baph September 4, 2013 at 7:25 pm #

    Silly question – do these returns include the distributions as well or just the price change?

  18. Canadian Couch Potato September 4, 2013 at 7:49 pm #

    @Baph: Reported fund returns always include distributions (which are assumed to be reinvested).

  19. jambr403 September 5, 2013 at 12:15 pm #

    Like Mother above, I’d also like to thank you CCP for creating this blog. I’ve put our RRSPs into the Complete Couch Potato portfolio and have been sleeping well and satisfied with the results. I came from a “Wealth Management” firm that charged 1.6% and high transaction fees. When the market dropped in 2008 they panicked and sold off lots of equities. Decided to bale in 2011 to your passive model and couldn’t be happier.

    My question to you is regarding the REIT allocation in the model portfolios. I have a small portfolio of rental units in AB and BC which I intend to keep forever. As such, do you think it makes sense to swap the REIT allocation in favour of something else? What would you suggest?

  20. ap September 5, 2013 at 2:16 pm #

    Would it be possible to publish model couch potato returns on a regular basis? (or is there somewhere else on the site that tracks them). I’d like to check in to see how I’m doing from time to time but it’s not easy to find something to compare my returns to.

  21. Canadian Couch Potato September 5, 2013 at 7:46 pm #

    @ap: My feeling is that reporting returns more than once a year is mostly distracting. (It’s also time-consuming for me to gather all the data.) As a long-term investor, what’s the point of tracking your returns more often than that? Would you change anything in your strategy if the returns were -10% or +10% over a quarter or six months? I usually end up doing at least one YTD update (like this one) along the way if there is some context to add, but I don’t think it’s helpful to worry about it more often than that.

  22. Canadian Couch Potato September 5, 2013 at 7:49 pm #

    @jambR403: Thanks for the comment, and for a good question. My guess is that your rental properties are probably not highly correlated with commercial and industrial REITs in Canada (especially if you own residential units). But that said, an easy fix might simply be to use a global REIT fund in your portfolio rather than a Canadian one. Then you can be sure there is no correlation at all.

  23. Brian September 6, 2013 at 6:30 pm #

    To me, this article is a story about psychology and how hard it can be to stick to a diversified investment plan when you see some “losers” in there.

    I’ll admit my weakness… I have found over time, I cannot stick with a pure index portfolio… it may make logical sense, but I cannot do it. What’s worked for me was reading about value investing by reading works by Benjamin Graham (e.g. the Intelligent Investor.) More specifically, the way he calculated the “intrinsic value” of a stock just made sense to me… just like bond duration and yield to maturity makes sense when I evaluate a bond or bond fund.

    If nothing else, value investing can complement index investing and help one spot when the market has gone crazy. Thanks to that reading, I got myself totally out of the market in late 2007. (I have brokerage statements to prove it, BTW.) I returned in summer 2009. Why? Because the valuations of some large sample companies I ran the numbers on started to seem reasonable again. Without understanding Graham’s “intrinsic value” method, I wouldn’t have been able to do it.

    A sample of one event, means next to nothing and I don’t know if my binary approach of investing in a diversified portfolio OR holding cash will hurt my long term return… but it’s what I do and so far it’s worked. I also see it like this… if I make a mistake and pull out into cash at a wrong time at worse I’ve given up some return and at best, I’ve lowered my risk and protected myself from a large drawdown. That feels like a better trade off for me… but I’m probably wrong… 🙂

    Anybody else like me?

  24. BH September 6, 2013 at 9:46 pm #

    @Brian – You might want to check out john Bogle’s red book ‘The little book of Common sense investing”. Watch the You Tube Documentary ‘Passive Investing: the Evidence the Mutual Fund Companies do not want you to know’ something like that anyway, both excellent insight into Passive Investing or the Couch Potato.

  25. BH September 6, 2013 at 9:51 pm #

    @CCP – What about replacing VTI with VUN and VXUS with VDU?

  26. BH September 6, 2013 at 9:51 pm #

    I use VCE, VUN, VDU and VAB.

  27. Canadian Couch Potato September 6, 2013 at 11:16 pm #

    @BH: Your ETF choices are just fine. One thing to be aware of is that VXUS includes emerging markets, but VDU does not.

    http://canadiancouchpotato.com/2013/08/20/etf-choices-are-less-important-than-you-think/

  28. Brian September 7, 2013 at 4:17 am #

    @BH Thanks, but I know all about passive, index investing and it’s advantages. As I tried to convey, it’s what I’m doing 95+% of the time; when I am fully invested. I just add that little extra which is, get out when “intrinsic value” is out of wack and get back in when it makes sense again. It’s working for me and I don’t see a downside to what I am doing.

    While I like indexing, I do wonder why it’s gospel that one must be a 100% indexer, 100% of the time and why one can never move to the sidelines when/if their sense of what is a reasonable price is broken.

    E.g. when I buy red peppers at the grocery store, I know there intrinsic value to me. If the price is right, I’ll buy, if it’s not I’ll stay out of the market for red peppers and come back another day. This is a really intuitive type of thinking when you are on a budget. I have done the same when buying a car and a house. How is the equity market any different?

    Warren Buffet was a student of Graham’s methods and his Berkshire Hathaway has consistently outperformed the SP500 over the long term including through the dot-com bubble and the 2008 crash. Vanguard’s own Large Cap Value (VIVAX) or Small Cap Value US (VISVX) mutual funds (which we can’t buy in Canada) have outperformed the Total US Market over the long term, yet, in effect these “value” funds are a type of active funds. There are more “active” funds that look for “value”, how about CDZ or CRQ outperforming XIC.

    If one gives up the pure indexing dogma and goes to the smart active dark side; in the Couch Potato portfolio, one could replace a portion of VTI with BRK.B, VIVAX or VISVX and replace a portion of XIC with CRQ or CDZ and likely boost the portfolio’s performance. Additionally, my method to pull out when the market valuations make no sense is likely (but not guaranteed) to improve the drawdown and avoid dumb entry points for new cash.

    Saying that indexing works well is correct but saying 100% indexing, 100% of the time is the only way that works or that is best is wrong.

  29. André September 7, 2013 at 7:38 am #

    Hello Dan,
    Should portfolio returns be better off (for a portfolio such has the complete portfolio) after a period of high volatilty rather than low? It seems to me that it should because of rebalancing (buy low/sell high) but would like to know if its really the case. If that’s the case, than I guess I should welcome those big swings from time to time and look at them as opportunities. That should protect (hopefully!) me from doing the wrong thing at the wrong time. Like not rebalancing or selling low/buying high.
    Thanks

  30. BH September 7, 2013 at 8:10 am #

    @Brian – I also have some BRK.B. It seems though with Buffet that success may have bred more success, in that I understand that people send him information on their large Family businesses so that he can consider buying them out or partnering with them. This is a way for him to have a major advantage at calculating intrinsic values on companies that others may have no chance in participating in without being in his stock. The documentary I mentioned discusses this and mentions that probably for most investors they are incorrect at calculating the intrinsic values probably 50% of the time. So there probably is some good luck involved for the average investor or ‘pro’ if they are winning at this and the tables may turn on them and probably will eventually.

  31. BH September 7, 2013 at 8:24 am #

    @Brian – One other thing I do not like is moving in and out of the Market, as this does trigger Capital Gains Taxes. I feel I’m better off buying and holding and reinvesting the dividends constantly. On timing the Market Bogle says this is a good way to change a ‘Winner’s game into a Loser’s game’. I’m obviously sold on Passive Index Investing.

  32. Canadian Couch Potato September 7, 2013 at 9:43 am #

    @André: Great question. The returns I publish for the Couch Potato portfolios assume annual rebalancing on January 1. If you were to instead rebalance every time a particular asset class suffered a big loss, your long-term returns would likely be higher. And this would be even more likely if the individual asset classes were very volatile.

    Rebalancing a portfolio of, say, government bonds and corporate bonds is not going to have a huge benefit, as both asset classes are relatively stable. But rebalancing a portfolios of equities, REITs and real-return bonds will make a bigger difference. This ideas is called “volatility harvesting”:
    http://blogs.cfainstitute.org/investor/2012/02/24/volatility-harvesting-from-theory-to-practice/

  33. Chris September 7, 2013 at 12:00 pm #

    @CCP: The statistical math in that CFA Institute article is terrible — nothing about the two thought experiments is correct. I’m surprised it was greenlighted by the editorial board (presumably also chartered accountants). I can’t even wrap my mind around what kind of misconception/error underlies the claim in the paragraph that begins “Here is a thought experiment…” and it’s impossible to make sense of the next paragraph without understanding what kind of error was made in the previous one.

  34. Canadian Couch Potato September 7, 2013 at 12:40 pm #

    @Chris: Maybe the original paper will express the idea more clearly:
    http://www.iinews.com/site/pdfs/JWM_Fall_2012_Parametric.pdf

  35. Dotcom September 7, 2013 at 4:40 pm #

    Why do the balanced portfolios have such a high allocation of Canadian stocks? Canada only represents approx 3% of the ACWI, yet most balanced funds have an allocation of 30%. Even the couch potatoe portfolios are invested 20 % in Canadian markets. Though lower than traditional portfolios, it still seems like overkill on Canada. Shouldn’t an ideal diversified portfolio reduce its exposure to the Canadian market, and add to its global exposure, or even add another asset class like infrastructure to the mix to diversify even more?

  36. Canadian Couch Potato September 7, 2013 at 4:51 pm #

    @Dotcom: Good question, which I have answered here:
    http://canadiancouchpotato.com/2012/05/22/ask-the-spud-does-home-bias-ever-make-sense/

  37. Dotcom September 7, 2013 at 10:43 pm #

    @ccp good points in that link. Thanks.

  38. Brian September 9, 2013 at 1:44 pm #

    @BH I don’t mind triggering capital gains vs. taking a 50% loss. One thing to note, it’s rare. I only get out of the market when things are crazy. E.g. one measure of crazy is when average market PE is greater than 25 and we’re not in a recession… e.g. when everybody is exuberant, I worry. When everybody is worrying, I’m happy.

    @Dotcom, I agree with you and have made this point before. Japanese investors 20 years ago probably made the same mistakes @CCP uses as justifications and it didn’t help them. My advice is stay very diversified but you need to figure out what that means for you.

  39. Meeko September 10, 2013 at 2:03 pm #

    I just started following an Uber-Tuber model (with some tweeks to fit in my and my wife’s work pensions) and have been happy so far. I believe that as long as you have a nice diversified portfolio of index funds/ETFs the returns are not as important as just making contributions. Very much like all the talk about “will interest rates go up”? “Should I renew my mortgage now or wait”? The main thing is not what your mortgage rate is that affects how long until you pay it off, but making larger payments and additional pre-payments that will crush it. Rates (interest or returns) are obviously important, but chasing the quick money is risky. Spend less; save more is my strategy. That being said, I can now relax in my new hot tub knowing my money is well diversified.

  40. Andrew September 15, 2013 at 5:12 am #

    Brian
    Check out the papers by Mebane Faber on using 10 month moving average to avoid drawdowns. This has been discussed in this blog as well.
    “A quantitative approach to tactical asset allocation”
    But consider whether such quant rules will be applied consistently to a T over time as they were in the back testing used in the papers.

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