Portfolio Diversification: Portfolio Diversification


What is asset allocation?: Cash Bonds Stocks Asset allocation is the process of combining asset classes such as stocks, bonds, and cash in a portfolio in order to meet your goals. What is asset allocation?


How important is asset allocation policy?: A: Variation in returns across funds attributed to asset allocation C: A fund’s total return attributed to asset allocation 100% 90% 40% 0 50 100 C B A Percent (%) B: Variation in a fund’s returns over time attributed to asset allocation How important is asset allocation policy?


Reduction of portfolio risk: Risk is measured by standard deviation. Reduction of portfolio risk


Potential to reduce risk or increase return: Risk is measured by standard deviation. Return is the compound annual return. Risk and return are based on annual data over the period 1970–2003. Portfolios presented are based on modern portfolio theory. Fixed income portfolio Return Risk 8.6% 7.8% Bonds 85% Cash 15% Potential to reduce risk or increase return 1970–2003


The case for diversifying: Time period illustrated is from 1956–1962. This time period was chosen as a dramatic illustration of stock and bond return behavior and how their often opposite movements reduced portfolio volatility. Annual return -20% -10% 0% 10% 20% 30% 40% 50% Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Bonds Stocks 1.9% 8.5% Average return The case for diversifying


Stocks and bonds: risk versus return: Risk is measured by standard deviation. Return is measured by arithmetic mean. Risk and return are based on annual data over the period 1970–2003. Portfolios presented are based on modern portfolio theory. Stocks and bonds: risk versus return 9% 10% 11% 12% 13% 10% 11% 13% 15% 16% 17% 18% 100% bonds 25% 75% – minimum risk portfolio 50% 50% 60% 40% 80% 20% maximum risk portfolio – 100% stocks Risk Return 12% 14% 1970–2003


Degree of correlation between equity sectors: 1992–2003 High Medium Low Consumer non- cyclical Basic materials Consumer cyclical Consumer non-cyclical Energy Financial Health care Industrial Technology Telecom- munications Utilities Basic materials Consumer cyclical Energy Financial Health care Industrial Tech- nology Telecom. Utilities — — — — — — — — — — Degree of correlation between equity sectors


Diversification in bull and bear markets: $2,513 $1,648 $500 $1,000 $1,500 $2,000 $2,500 $3,000 1992 1994 1996 1997 Stocks Bonds Bull market $900 Bear market $971 $1,528 $1,000 $1,100 $1,300 $1,500 $1,700 1997 1999 2001 2002 $1,200 $1,400 $1,600 Diversification in bull and bear markets


Diversified portfolios and bear markets: $1,000 Diversified portfolio: 35% stocks, 40% bonds, 25% Treasury bills. Hypothetical value of $1,000 invested at month-end December 1972 and June 1987, respectively. 1987 market crash Dec 1990 $500 $1,500 Jun 1987 Jun 1988 Jun 1989 $1,324 $1,227 Mid-1970s recession $1,149 $1,014 Jun 1976 $500 $1,500 Dec 1972 Dec 1973 Dec 1974 Diversified portfolio Stocks Diversified portfolios and bear markets $1,000