In a recent Vanguard column, the topic of diversification was discussed from a purely risk mitigation perspective. The article explained how diversification across asset classes seeks to reduce the impact of losses in a portfolio when one asset class falls significantly in value. The idea being that you’re increasing the odds that parts of your portfolio will hold their value when others fall.
In concept, the idea sounds sensible, and that’s why the vast majority of industry and retail superannuation funds are invested across a range of asset classes in what are known as “balanced” funds.
You can read the Vanguard article here.
By diversifying across asset classes, the performance path of the portfolio is typically less volatile. In other words, there are less “bumps” along the way. Diversification, whilst helping to smooth out the path of returns, also carries with it a huge risk that your wealth doesn’t grow at the rate it needs to. Indeed, it can easily be shown that a “balanced” diversified investing approach is guaranteed to create a handbrake on a portfolio’s performance.
Sure, it will be a smoother ride but at what cost?
It’s suggested in the article that it’s much better to have a smooth 8.3% p.a. return over 80 years than it is a “bumpier”10.5% p.a. over the same time.
Is 8.3% p.a. success?
Evidence and research show that for a couple to be able to retire and live a comfortable and self-sufficient 20-year retirement, which may not be long enough to plan for, they’ll need to have contributed 9.5% of their salary each year to their investment each year for 40 years returning a minimum of 10.25% p.a.
Research by ASFA (Australian Super Fund Association) and ICI.ORG (Investment Company Institute) in the U.S. both show very clearly that average and median nest eggs are around a quarter to a third of what they need to be to enjoy a self-sufficient and comfortable ‘second life’.
In short, 8.3% p.a. over 40 years isn’t going to get you there. This is one of the main reasons for the huge growth in the number of self- managed superannuation funds in Australia. Investors are seeking better returns by taking more control over their investing decisions.
A picture paints a thousand words and a quick look at history below shows us the impact of diversification over the longer term.
Diversification is a risk management strategy. Its primary aim is to reduce the impact of large market declines. The problem is that Fund managers use a “one size fits all” approach for all their customers regardless of age. In doing so they produce a “slow down” effect on portfolio returns.
Data sourced from CRSP (Centre for Research into Securities Prices) shows the impact that diversification has on a portfolio’s performance. The third line down on the chart is the “equity curve” or path produced from a diversified portfolio split 60/40 between stocks and bonds.
It shows that $1000 invested into a diversified portfolio grew to $1,219,945 over the last 93 years, excluding fees. Assuming an annual fee of 1% over the 93 years will cut this number in half!
The second line down on the chart shows the impact of investing $1000 into the S&P500 index over the same time frame, growing to $6,965,161, excluding fees.
The top line is the Share Wealth Systems “Wait and Win”, or buy and hold, single index ETF strategy growing $1000 into $17,881,980. Annual fees for this strategy afre currently less that 0.1% p.a. and would have only reduced the final total by around 8% instead of 50% for the balanced fund scenario.
So yes, the path of diversification is a smooth one. But what’s more significant is the hand brake effect it produces over the long term which restricts the growth required for an investor to achieve their end goal of a comfortable and independent 20+ year retirement.
It does however also achieve another of its aims, and that is to reduce the “drawdown” or reduction in portfolio value during large market falls. This is evidenced by the smaller dips in its path compared to the S&P500 and “Wait and Win” paths.
But here’s the critical point. The smaller dips are occurring on a greatly reduced portfolio value, since its growth is so much lower in comparison to that of the SP500 and “Wait and Win” approaches.
By choosing to invest in a balanced fund for the long-term an investor is in effect guaranteeing a retirement funding shortfall. So, what type of approach could a Self-Managed Superannuation Fund employ to improve the chances of not falling short of its goal?
The most effective way to produce better returns is to diversify across investing strategies in the Stock market rather than diversifying into other asset classes outside the stock market. This is best achieved using one or several different investing strategies in the one asset class (stock market) based portfolio.
This is sometimes called a Core & Satellite approach. It has significant advantages in that it doesn’t stifle growth by investing in poorer performing asset classes. This combined approach also helps to iron out some of the bumps and provides a smoothing of the overall investment path.
As an example, an investor could allocate half of their funds to the Core portfolio and invest using a Buy and Hold approach, into a high-performing index ETF that historically beats the ASX200 and SP500 benchmarks.
The other half of the investor’s funds could be allocated to a more active Satellite portfolio/s. That portfolio would employ a self-directed trend following strategy(ies). It will invest into individual stocks on an Equal Weighted basis, and can go 100% into cash when markets have severe downturns, thereby helping to reduce overall portfolio draw down.
The path of such a portfolio can be seen below compared to that of QSuper’s Balanced fund over the past 16 years.
The path of the balanced fund is again very smooth because of its asset diversification. It’s performance however, is a long way behind that of the combined (diversified) Buy and Hold Single Index ETF and the equal weighted stocks-based strategies.
Investors adopting a similar approach may have a bumpier ride than the balanced fund but are much more likely to achieve their retirement goals on time and well ahead of the industry standard balanced funds.
In summary, the dollar amount of growth that is lost in rising markets due to diversification is far greater than the dollar amount that is saved in falling markets by diversification.
I acknowledge that this may not be for everybody even though everybody needs it. This is for those investors that want to take control of their financial futures and who have a desire to do better than the herd.
Click here to find out how to invest better than the herd – anybody can.