Diversify subsection 1

Investors are often their own worst enemy, buying high and selling low, when sticking to a long-term strategy would serve them best. For example, individuals routinely underperform the mutual funds they invest in through poor timing of their transactions. According to Morningstar, for the 10 years ending in 2014, mutual fund investors in aggregate earned an average annualized 5.21% return, even though the funds they were investing in earned 5.75% themselves.* A more globally diversified portfolio, simply rebalanced annually would have earned an even better 6.7% over the same period.**

Investors often hear about the benefits of diversification and rebalancing, but few practice it effectively, instead chasing after investment fads, because they don’t understand the underlying reason for the success of rebalancing a diversified portfolio. So why does it work?

Diversification works by reducing risk because different assets behave differently depending on what’s going on in the economy. When stocks are down, bonds are often up, and vice versa. So if you own a variety of different assets, it’s unlikely that they will all be down at once.

Rebalancing works by enhancing return because over time certain assets will outperform other ones, becoming a larger proportion of the portfolio. By rebalancing to restore the portfolio’s original proportions, you automatically introduce a “buy low, sell high” discipline to your portfolio, which over time will probably do a lot better than investors who make the mistake of doing the opposite!

But what do we mean by “high” and “low” really? We believe (and the evidence backs us up) that the return on an investment depends on the price you pay for it relative to what it will pay you in the future. This is a concept called yield. Your bank account pays you a yield (probably not a very good one!) and investments do too. Whether it’s the yield to maturity on a Treasury bond or the real earnings yield on the stock market, the yield on an investment tells you a lot about the return you can expect from it over the course of several years. All else equal, a higher yield (i.e. a low price) on an asset means a higher expected return. As an asset’s price rises, its yield decreases, and it becomes a less attractive investment.

Diversify sub 2

Rebalancing basically works by selling lower yielding assets to buy higher yielding ones, which over the long run should boost your expected return. But here’s the thing, most advisors and automated solutions like target-date funds simply rebalance back to fixed proportions, like “60% stocks, 40% bonds”, regardless of the different yields between assets. This has the benefit of being simple and easy to do. But if you’re willing to do a little math, following a strategy that dynamically overweights assets with relatively high yields should have an even higher expected return.

One of the first things you learn in a college finance class is that risk and return go hand in hand. The higher return you want, the more risk you have to take. But everybody wants a high return, and nobody likes the risk of losing money. We have to strike the right tradeoff. What we have is a mathematical optimization problem. Most solutions use cookie-cutter asset allocations based loosely on the very-long-run average risk and return of different asset classes, as if nothing had changed about the stock and bond markets over the last 50 years. We prefer to get our hands dirty and actually optimize our clients’ risk and return in real time based on real data.

Using the mathematical techniques of modern portfolio theory, we can craft an asset allocation that fits your risk tolerance, while increasing exposure to higher-yielding assets that will likely outperform set-it-and-forget-it solutions over the long run.

Diversify Subsection 3

*Source: Morningstar

**Source: JP Morgan Asset Management, based on a hypothetical portfolio with the following weights: 25% in the S&P 500, 10% in the Russell 2000, 15% in the MSCI EAFE, 5% in the MSCI EME, 25% in the Barclays Capital Aggregate, 5% in the Barclays 1-3m Treasury, 5% in the CS/Tremont Equity Market Neutral Index, 5% in the Bloomberg Commodity Index and 5% in the NAREIT Equity REIT Index. Does not include fees.

References

Rebalancing a diversified portfolio can enhance returns while reducing risk: “Diversification, Rebalancing, and the Geometric Mean Frontier” by Bernstein and Wilkinson (1997) and “The Benefits of Rebalancing” by Buetow, et al. (2002)

Yield measures can explain subsequent returns on stocks and bonds: “What Risk Premium is ‘Normal’” by Arnott and Bernstein (2002). and “Expected Returns on Major Asset Classes” by Ilmanen (2012)

Modern mathematical optimization approaches to portfolio management can deliver more optimal asset allocations with better performance: “Developing Robust Asset Allocations” by Idzorek (2006) and “Multi-Asset Portfolio Optimization and Out-of-Sample Performance” by Bessler, Opfer, and Wolff (2014)