Where the covariance of an asset class relative to equities is sufficiently low or possibly even negative, its addition to a portfolio can improve risk-adjusted returns even if the asset itself exhibits tremendous volatility and has relatively low compound returns. In this case, the strong performance of the S&P GSCI during periods of weak equity returns in the early and late 1970's, late 1980's and early this decade dramatically improved the risk-adjusted return of the total portfolio over the entire period. Patient, long-term strategic asset allocation is paramount in accessing the free lunch.
Today, many analysts assert that diversification is no longer effective in the context of a truly global economy. They believe the returns of risk assets are now so correlated that the free lunch is at best a snack. In evidence, they cite the poor performance of both U.S. and foreign stocks over the last decade.
To the contrary, diversification that incorporated style and size elements and a more diverse mix of assets delivered superior risk-adjusted returns. This is evidenced in the following graph which compares the return of a twelve asset class portfolio (in red) to that of a two asset portfolio (in brown) comprised of U.S. and foreign stocks over the past decade. The broad diversification of the twelve asset portfolio – comprised of equal weights of U.S. large and small company stocks; U.S. large and small value stocks; foreign large, large value and small company stocks; emerging market stocks; U.S. REITs; hedge funds, gold and commodities – resulted in substantially higher returns with less volatility than the two asset portfolio.
Diversification's free lunch is still being served. The biggest helpings go to those who order a robust assortment of assets and are patient enough to remain seated until the entire meal is on the table.
August 31, 2010
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