Studies have shown that there is no perfect correlation between two different asset classes. Stocks of large companies do not move in lockstep with stocks of small companies. Bonds do not move at the same time as stocks. Therefore a portfolio with one asset class will not behave the same as a port-folio with two or three asset classes. In Figure 4.1 we see real returns on stocks, bonds, and treasury bills for the year 2000. Note that the returns vary widely. Contrast those returns with the returns on the same three asset classes in 1999 in Figure 4.2 and you see yet another picture.
The closer we look, the more obvious it becomes that one asset class can complement another, and the greater the number of asset classes that are not closely correlated, the better. I like the metaphor of the eight-cylinder engine. You get a smoother ride with a V-8, because as one cylinder is coming down another is on its way up, while another is bottoming out, and so on. In Figure 4.3, the 50 percent stock/50 percent bond line shows a steadier return compared with the 100 percent stock line or 100 percent bond line. “Poor performance in one investment can be offset by good performance in another,” writes Frontier Analytics, a leading firm in asset allocation, regarding this graph. Add more asset classes and you may further reduce volatility. More does not necessarily mean better; so the added value of an advisor is to achieve the right mix.
Still, much of the work regarding proper diversification is based on academic studies. This is called modern portfolio theory (MPT). One of the important assumptions MPT is built on may also be called the butterfly effect. It suggests that there is an interaction of all things, so that a butter-fly flapping its wings in Florida affects, if only in a small way, the air in New York and California. If there is an interaction among assets, and if there is a way of putting this interactive denominator to work in portfolio design, then we may be able to develop a plan that is less risky than the portfolio’s riskiest asset. Strange as it may seem, we may get a free lunch. At the same time, we may produce more return than cash, short-term bonds, or CDs, which are highly predictable assets but have poor long-term results. When securities get into oversupply in one sector of the economy, money begins to move to another sector or asset class that has less supply. When securities go down because few people find them attractive, they eventually become cheap enough to begin to attract bargain hunters willing to take the risk of owning what others do not want. Although we do not know when and where money will move next, diversification helps keep us invested
Tags: investment