When it comes to investment portfolios, the term diversification is a bit like the word “ironic.” People use it all the time, but almost nobody really knows what it actually means.
Most people that I meet think that diversification means having a lot of different investments, in particular, lots of different mutual funds. “I have 15 different mutual funds,” a friend told me once. “I must be diversified.”
And, in a limited sense, my friend was right. Owning several mutual funds – and thus many different stocks and bonds – is a form of diversification. It is far safer to own dozens, if not hundreds, of stocks instead of one or two. The problem is that all of my friend’s stock mutual funds – and, indeed, most investors’ – hold large U.S. stocks and nothing else.
Unfortunately, this basic level of diversification is usually where most people stop. It’s a costly mistake. How costly? Well, on average, this lack of diversification will reduce your portfolio by 50% over twenty years, so pretty darn costly.
Investors need to stop looking only at the number of stocks that that they own and start looking the characteristics of those stocks. Decades of academic research has proven that spreading your stock holdings among those different characteristics, known as “factors,” can dramatically reduce your portfolio’s risk and increase your returns.
So just what are these factors, and how important are they when it comes to your portfolio?
Well, let’s start with the three oldest and most studied factors. (Research over the past two decades has uncovered additional factors, but that’s a topic for my next article.) The first factor is called the “Market” factor, or market premium. That’s simply the extra return that you get for investing in large stocks instead of a three-month Treasury note. Basically, it’s the premium that you get for taking the risk of investing in stocks instead parking your money someplace quite safe – at least in the short run.
From 1927 to 2012, the Market premium was 5.85% a year. In other words, you earned on average an extra 5.85% more each year by investing in stocks than you would have earned investing in a three-month Treasury note. Of course, that extra return came with a lot of extra risk.
The next factor relates to the size of companies and the returns on stocks from small companies versus large companies. Since 1927, small company stocks have earned 2.3% a year more than large company stocks. Once again, that extra return, known as the Small Premium, came with additional risk.
The final factor concerns the price that you pay for a stock. Not surprisingly, companies with strong earnings growth – known as Growth stocks – tend to be expensive to buy. On the other hand, companies with slow earnings growth, or even falling earnings, tend to be fairly cheap – and thus their name, Value stocks. Well, it turns out that the cheap – but distressed – stocks are a better deal than the expensive – but with good earnings – stocks.
Since 1927, value stocks have earned 3.98% a year more than growth stocks. Interestingly, in this case, that extra return – known as the Value premium – didn’t come with additional risk. The likely culprit for the additional return may simply be that investors prefer holding stocks of growing companies rather than stocks of distressed companies and are willing to pay a bit extra for that feeling of safety.
Here’s the recap:
- Market Premium 5.85% annual
- Small Premium: 2.30% annual
- Value Premium: 3.98% annual
It’s important to understand that the vast majority of investors own only stock mutual funds that have large company stocks, either U.S. or foreign companies. Occasionally, I’ll see someone who owns a mutual fund that claims to hold small companies stocks, but often a quick look under the hood of the mutual fund shows that those companies are typically more mid-sized companies.
As a result, most investors own only the Market premium. Does that sound diversified?
Now, let’s look at what that lack of diversification costs investors.
Let’s say that your typical investor has 60% of their money in mutual funds that are similar to the S&P 500 and 40% of their portfolio in 5-year Treasury bonds. Since 1926, this investor has earned on average 8.50% a year.
Now, let’s say that we add some of the Value premium so that the portfolio looks like this: 30% in the S&P 500, 30% in Large Value and 40% in 5-Year Treasury bonds. The annualized return increases to 9.60% a year.
Next, we add small value so that the portfolio looks like this: 15% in the S&P 500, 15% in Large Value, 30% in Small Value and 40% in 5-Year Treasury bonds. With small value added to the portfolio, the average annual return grows to 10.66%.
That 2.16% a year gap may not look like much, but the difference in your final portfolio is huge. Let’s look at what a $1 million portfolio looks like after 20 years with each portfolio:
- Typical Investor: $5.11 million
- Add Value: $6.25 million
- Add Small and Value: $7.58 million
The truly diversified investor ends up with $2.47 million more, or nearly 50% more money.
Most investors focus only on asset allocation – the mix of stocks and bonds. Of course, this is extremely important. However, to achieve true diversification, investors also need to add Factor diversification to their portfolios. If not, they risk failing to reach their financial goals.