Why Diversification Still Works

By Robb Lovell, MBA

There is an old expression in investing that “there is no free lunch”.  To explain this expression, it essentially refers to the idea that you can’t get something for nothing.  In other words, the prospect of higher returns brings with it great risk.  This expression very much goes hand in hand with the equally popular expression “Don’t keep all your eggs in one basket”, an expression which highlights the single exception to this risk/reward rule... Diversification.

Diversification is the spreading of a portfolio across asset classes and the spreading out of funds across various investments within those classes.  This notion of diversification being a “free lunch” was based on Nobel winning research into modern portfolio theory which stated that by mixing the right combination of assets could increase the rate of return and reduce the risk.  The key to this was taking advantage of the tendency of different assets to react in contrasting ways to market movements and other economic events.

With the Global economic meltdown of 2008, we saw many assets that were, in theory, supposed to move in different directions to each other instead move down in tandem, so given this, does this mean that the free lunch of diversification is over and this notion is outdated?

Recently, a Toronto based capital management firm completed a study in which it examined the performance of six different types of investments from January 1972 to July 2010 and looked specifically at their rate of return and their volatility (standard deviation which is the most common way that the investment industry measures risk – the larger the number – the bigger the swings – the higher the risk).

Specifically, this study looked at six asset classes, specifically, Real Estate Investment Trusts, Stocks in Canada, Stocks in the US, Stocks in the Rest of the World, Commodities and finally, Gold.

The firm started with a portfolio made of 100% of Canadian stocks and then began adding the other six asset classes, one at a time.

At the end of each year they added a rebalancing to this theoretical portfolio which the target weighting would be maintained so that the profit was trimmed off the outperforming sectors and then added to the underperforming sectors.

What was found was that with each new asset class added to the portfolio, the additional diversification worked, the rate of return increased while the volatility or risk decreased.

What can be gained from this study as far as insight for the investor is that Diversification does work to effectively reduce risk and increase returns.  However, it is notable that diversification does not always work in the short term; it most certainly works over time.  Also, rebalancing annually works well but one must be cautions not to rebalance too often.

This rebalancing is absolutely key to maintaining a portfolio.  At 7th Wave, we meet with clients every 6 to 12 months to completely review a portfolio and determine what changes are required. 

We also carefully and methodically diversify client’s portfolios across asset classes and within each asset class.