New Insights Into Portfolio Diversification

By Craig L. Israelsen, Ph.D. 

If investors could know what the future will be, then they would invest only in winning equities without risk. They would only play offense. The fantasy of picking only winning investments clarifies the real purpose of portfolio diversification: To play both defense and offense at the same time. Craig Israelsen’s Clarifying the Purpose of Diversification explains how to mimic the return of winning equities while reducing the volatility of returns.

In the article, Israelsen tracks several asset allocation “recipes” over 49 years in preretirement accumulation mode and post-retirement distribution mode. Diversification is a lifelong strategy and, by design, is not exciting. But it will smooth out returns, which becomes crucial as investors begin to withdraw from their portfolios in retirement. Israelsen also shows that chasing higher risk for higher return does not inherently pay out more in the end, especially when investments may need to last 25 years or more in retirement.

Some topics that the article highlights include:

• The annualized return and risk of different asset allocations
• Which diversification strategies have the best chance of lasting through retirement
• The asset classes that can make up a diversified portfolio
• The expense of building a broad, multi-asset portfolio 

By Paul Merriman

Another downside to chasing only potential winners is that investors do not weight equities equally. Paul Merriman explores this concept further in Digging Deeper Into Diversification. He shows why investment victory is more often found through preserving gains via diversification than in seeking more gains.

Most total U.S. market indexes, such as the S&P 500 index, are capitalization-weighted. They also don’t weight equities equally, as a reflection of the U.S. economy. Giant companies have an outsized influence in a cap-weighted index, even though the index covers a diverse set of companies. Merriman shows that there are easy and inexpensive ways to further diversify a portfolio by equally investing in a blend of equity asset classes.

Some topics that the article highlights include:

• The important distinction between capitalization weighting and equal weighting
• Performance comparison of U.S. equity asset classes over 40-year periods
• Merriman’s selection of exchange-traded funds (ETFs) that cover his recommended asset classes
• 10 more things to know about diversification

As an important check, the article reminds investors that a diversified portfolio will never provide the best performance, as there will always be some underperforming investments. But with the goal of preserving gains, a diversified portfolio will never deliver the worst performance either.