Monday Morning: For diversification, think along class lines

At most conferences I attend, there is a moment of epiphany, an “aha!” moment when something long buried in the recesses of my mind is dragged to the surface.

Such a moment occurred last week during a presentation by Roger C. Gibson at the Spring Development Conference in Scottsdale, Ariz., hosted by the Investment Management Consultants Association. Mr. Gibson, president of Gibson Capital Management Ltd. in Pittsburgh, spoke on the “rewards of multiple-asset-class investing.” I think his speech should have been entitled, “The rewards of true diversification.”

During the late, great Internet boom, many investors – myself included – came to think of diversification solely in terms of stocks. If we had portfolios that included large-cap and small-cap stocks, and value and growth equities, we were diversified, we thought.

Certainly, it was better to own all these kinds of stocks than one kind, but they all belong to the same asset class – U.S. equities – they are more correlated with one another than with other asset classes. So the portfolios weren’t truly diversified.

The true power of diversification is when investments are spread across asset classes that have low correlations of return.

Mr. Gibson’s speech focused on diversification across four equity-based asset classes: U.S. equities, non-U.S. equities, real estate securities and commodities.

Examining the returns of each asset class between 1972 and 2002, he found that an equal-weighted portfolio that included all four assets would have produced higher returns with lower volatility than would have any of the individual assets.

For example, a portfolio using all four asset classes produced a compound annual return of 12.52%, compared with 12.2% for real estate securities, the highest return by a single asset class for the period. Commodities had the second-highest return, 11.19%, followed by U.S. stocks, 10.93%, and non-U.S. stocks, 10.16%.

One dollar invested in the diversified portfolio at the beginning of 1972 would have grown to $38.95 by the end of 2002. One dollar invested in U.S. stocks would have grown to only $31.95.

The standard deviation of return of the combined portfolio was 11.33%, lower than any single-asset portfolio. The lowest standard deviation for any asset class was 16.72% for real estate, and it was18.03% for U.S. stocks.

Thus, by combining four asset classes with low correlations, it was possible to increase return while reducing risk, just as Harry Markowitz predicted in his Nobel Prize-winning paper 50 years ago.

While these return and standard-deviation figures are based on the appropriate index returns for each asset class, it isn’t just a hypothetical strategy. Such an asset allocation can be implemented, Mr. Gibson said.

Index and exchange-traded funds are available for U.S. and non-U.S. stocks. The Vanguard Group Inc. in Malvern, Pa., has a real estate investment trust index fund, and Dimensional Fund Advisors in Santa Monica, Calif., has a real estate securities index fund.

For commodities, an investor could use the Oppenheimer Real Asset Fund, which closely tracks the Goldman Sachs Commodities Index.

Mr. Gibson noted that his study looked only at diversification within the equity part of the total portfolio. An investor must also decide how much to invest in long bonds and how much in short-term debt. Each of these can also be diversified.

Adding bonds will further reduce volatility, but it may also reduce long-term return.

Mr. Gibson’s book, “Asset Allocation: Balancing Financial Risk” (McGraw-Hill Trade, 2000), discusses these ideas and belongs on the bookshelf of every serious investor and investment adviser.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.