If you just started investing in the past year, chances are you’ve struggled recently. A portfolio full of high-performing pandemic tech stocks recently crashed, with some falling more than 50% from all-time highs.
If you are experiencing these losses and are looking for a way to invest more sustainably for the long term, this article is for you. Turns out there’s a free lunch in investing, and it’s called diversification.
We can define diversification as spreading your risk so that you don’t have all your eggs in one basket, so to speak. Over time, diversification helps reduce risk and increase returns.
But what does that imply? What should investors buy and hold in their investment portfolio to become truly diversified? Let’s look at the three factors that seem to me to be the most important.
Diversify across asset classes
Asset classes are categories of investments that you can include in your portfolio. The best known include stocks and bonds, such as the famous 60/40 portfolio, but can also include alternative assets, such as precious metals, commodities and real estate investment trusts (REITs).
We want to diversify asset classes because they don’t always move together. The beauty of asset class diversification is that a portfolio of risky and volatile assets that are not too correlated will actually have better risk-adjusted returns than a portfolio that only holds one asset. In a way, each advantage compensates for the other.
For example, an investor holding long-term Treasury bonds during the crashes of 2001 and 2008 saw a positive return, as the stock market fell. Recently, when stocks and bonds fell due to impending interest rate hikes and high inflation, gold and oil soared. A good portfolio balances its source of risk between different assets.
Below I have included a backtest of a diversified portfolio containing 50% stocks, 30% Treasuries, 10% gold, 5% commodities and 5% REITs against the S&P 500 Notice the higher risk-adjusted return and the lower maximum drawdowns.
Diversify across geographies
Investors often maintain a home country preference, where they overweight domestic stocks in their portfolio relative to their true weight in global market capitalization. A Canadian investor generally holds between 30% and 50% of his portfolio in Canadian equities. American investors generally have between 70% and 100% of their portfolios in American equities.
While a modest bias in favor of the country of origin reduces exchange rate risk, volatility and improves tax efficiency, an excess can lead to concentration risk, that is, the risk that your country do badly. Global stock markets are cyclical, with various countries outperforming and then lagging in turn.
From 2000 to 2010, the United States had a lost decade, where the return of the S&P 500 did not beat the Treasuries. During this period, Canadian equities and emerging market equities performed well. Over the next decade, from 2010 to 2020, we saw the opposite, with US equities deteriorating. A good portfolio holds different markets at their true weight.
Below I have included a backtest of the US stock market against the international stock market. Notice how each takes turns outperforming each other depending on the time period.
Diversify risk factors
A risk factor is a source that explains stock market returns. The best known of these is market beta, which is simply exposure to the stock market. By investing in stocks, you are exposed to market beta, which compensates you for the risk of stocks with a higher return compared to bonds and other assets.
Beyond market beta, there are other factors that explain the excess returns (alpha) generated over time. These include factors such as value and size. Since value stocks are riskier than growth stocks and small cap stocks are riskier than large cap stocks, we expect them to pay a higher risk premium over time. time.
Investors aware of this can position their portfolios to outperform by overweighting (tilting) these stocks. In particular, small-cap value stocks pay the most outsized risk premiums. These factor risk premia have been pervasive for decades and statistically significant, even though large-cap growth has recently outperformed.
Below I have included a backtest of US small cap value stocks against the S&P 500. Notice the massive outperformance over time, with better CAGR and higher risk-adjusted returns.