Diversification Really Does Pay Off
January 26, 2010
by Geoff Considine, Ph.D.
The last decade severely tested investors belief in the value of diversification and strategic asset allocation, leading some in the financial media to assert that diversification and asset allocation failed and were worthless during the crash of 2007-2008 (see, for example, here). Now is an ideal moment to look back and assess the carnage.
I use a test case to examine whether diversification and strategic asset allocation failed. By comparing the performance of diversified portfolios that I proposed well before the crisis to that of the S&P 500, I quantify the value of true diversification.
Diversification worked, even under the stressful conditions of the last two years. A diversified portfolio still lost money, but a retrospective analysis shows diversification had its expected impact on portfolio performance.
It has been four years since I wrote the article Tuning an ETF Portfolio Using Monte Carlo Simulation. I published a summary of this article on Seeking Alpha at that time. I took a well-diversified portfolio of ETFs and showed what a Monte Carlo model would suggest in the way of improvements. The starting portfolio of ETFs had been proposed by David Jackson, founder of Seeking Alpha, in an earlier analysis. The original ETF portfolio is shown below:
This portfolio has a lot to recommend it, with broad exposure across large, medium, and small market capitalization and substantial allocations to international developed and emerging markets. The portfolio spreads its 20% allocation to bonds across short-, medium-, and long-term maturities. There is also a 5% allocation to REITs. The expenses on this portfolio are quite low, too, thanks to the use of ETFs. Overall, most individual investors would be better off with this portfolio than whatever they have now (see here).