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Seeking the Other Kind of Alpha: Diversification

You know there's value in intelligent asset allocation, but are you getting the full benefit of true diversification?

Articles by Dan Egan
By Dan Egan Managing Director of Behavioral Finance & Investing, Betterment Published Dec. 06, 2013
Published Dec. 06, 2013
4 min read
  • True diversification not only improves returns, it can—and should—reduce investing stress.

  • Less stress can help you maintain optimal investor behavior—which also typically helps returns.

  • Here's the bottom line: When it comes to investing, you don't want the stress of going after "the best", you want the best possible returns. Learn more about Betterment

Most investors know that there is value in intelligent asset allocation, but many of them don’t get the full benefit of it.

The first reason is that true diversification is trickier than many people think, as I’ve written about before. It’s more than just having a wide variety of securities in your portfolio. True diversification comes from including a mix of different economic growth factors in your portfolio—to improve returns.

The second reason is just as powerful, but more subtle. A well-diversified portfolio will cause you less stress, and will therefore reduce your emotional reactions to losses. This is far more valuable than you might think, because making decisions when you’re tense rarely goes well.

Why you should behave

To understand why this is the case, we need to discuss two major components of modern behavioral finance: narrow framing, and loss aversion. Narrow framing is the tendency to look at components of a decision in isolation, like focusing on individual trees, rather than the forest. When you narrowly frame in an investing environment, you tend to consider each asset in isolation, rather than how they work as part of the whole. This can lead to some inconsistent investing decisions, because you may over-focus on preventing losses.

Loss aversion is the tendency of investors to fear losses almost twice as much as they are attracted to equivalent gains. Because of this, most people tend to react more strongly to losses than to gains.

Combined, loss aversion and narrow framing mean that DIY investors can lose the psychological benefit of diversification. A diversified portfolio’s return is less likely to show a loss than any single asset within that portfolio—yet any individual asset’s loss will garner more attention.

Diversification wins

The better your diversification, the happier you’re likely to be with your returns. The better your diversification, the happier you’re likely to be with your returns. However, this is only the case if you look at the top-line, portfolio returns. If you attempt to manage a 12 asset class portfolio yourself, you’ll likely lose the second, psychological diversification benefit.

Consider this: Since 2004, a Betterment 60% stock portfolio has experienced a monthly loss only 36% of the time.¹ However, if you look at  the same underlying assets individually, the chance of at least one of those assets having a loss in any given month is 82%.

Imagine that there is only a 36% chance of seeing a month-on-month loss, compared to 82% for a given asset (the odds are also higher if you’re looking at two or three assets, as in the chart below). This reduction in stress is one benefit of not having to manage a diversified portfolio yourself.

Betterment Portfolio 3 or more assets 2 or more assets At least 1 asset
Chance of seeing a monthly loss (to date) 36% 50% 57% 82%

Peace of mind, illustrated

That’s why we engineered the Betterment portfolio to help you get the benefit of the entire forest, without having to focus on the individual trees, so to say. A Betterment portfolio manages all of that for you, and delivers the benefit of diversification, both in terms of investment performance, and less stress.

As an illustration, I’ve recast the traditional block chart, which typically shows highest- and lowest-performing asset classes year by year, like this one. These charts are usually used to showcase that last year’s top performers aren’t likely to be next year’s top performers, and vice-versa for worst performers.

The Callan Periodic Table of Investment Returns

 

This chart, produced annually by Callan, shows the movements of asset classes over the years, but it doesn’t capture the pain of loss or the pleasure of gains over that period. It also doesn’t demonstrate the psychological power of diversification on your returns, month by month.

To get a sense of diversification in real time—or close to it—I recast the standard block chart to show the movement of securities within the Betterment portfolio, month over month, over the past decade. In the chart below, you can see our 12 equity and bond ETFs² are in blues and greens. Using a central axis, you can see both positive and negative returns. I’ve laid it out vertically so that scrolling forward (up) and backwards(down) in time is easier.

Click on the image below to see the full chart.

Diversification 2013

As you can see, each asset class moves independently—which is exactly what you want. Different economic growth factors compensate for each other, resulting in a better risk/return tradeoff. But the real winner is the 60% stock Betterment portfolio (in orange), for approximately the last 10 years. It serves as a compelling illustration of an old Latin saying: In media stat virtus, or “Virtue lies in the middle”—which is at the heart of Betterment’s long-term investing strategy.

Note that in a well-diversified portfolio like this, there will always be assets that overperform—and underperform—the Betterment portfolio. In fact, we selected this specific mix of securities so that your Betterment portfolio never (or rarely) goes to extremes. The return for our 60-40 allocation was 6.3% over the past decade.³

That’s diversification alpha. You’re not outperforming the market, you’re outperforming what you could achieve on your own if you simply went after “the best” in each asset class.

The best investing over the long-term isn’t about looking for the highest performing asset at any given moment, it’s about getting the best possible risk-adjusted returns over time, for the least amount of stress.


¹Read our full returns disclosure. We’ve updated our pricing structure since this article was published.

²These represent the securities in our forthcoming portfolio.

³Read our full returns disclosure. We’ve updated our pricing structure since this article was published.

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