Some Lessons In Diversification

Morningstar recently used its database to show how a series of three-fund diversified portfolios would have performed over the last 20 years. The idea was to use the three-fund portfolio idea to simplify investing and show how investors could improve their diversification. One point to keep in mind is that the last 20 years was unique and isn’t likely to be replicated in the next 20 years. Another is the three-fund portfolio doesn’t provide true diversification. It’s heavily dependent on stocks for returns and volatility.

The first thing to notice is that the returns are clustered. No portfolio made as much as 1 percentage point per year more than another. This compression is time-period dependent. As we saw with the initial chart, domestic stock and bond returns were separated by an annualized 2 percentage points for the 20-year stretch, as opposed to roughly 6 percentage points over a full century. International equities were even more depressed, barely beating U.S. bonds.

Thus, over the long haul, asset allocation wasn’t terribly important. The three-fund investor reaped greater profits by holding more stocks (albeit at the cost of enduring significantly more losses during 2008) and was better off staying home than moving heavily into international stocks, but neither effect was large. Nor were they reliable. This time around, stocks modestly beat bonds, and U.S. companies outgained their overseas rivals. Next time, they might not.