The Basic Tenet of Portfolio Construction: Diversify



The basic tenets of portfolio construction.

Finally, owning a portfolio solely focused on the United States may lead to sub-optimal risk-adjusted returns. In other words, investors may be taking on risk that could otherwise be managed with diversification. This is a particularly important point today as stock correlations have fallen to their pre-crisis level, suggesting a greater benefit to diversification. To be sure, diversification isn’t a magic elixir, and it may not protect against market risk or loss of principal. The biggest caveat is that it’s least likely to work when most needed, i.e. during a crisis. Instead, the benefits are derived, almost imperceptibly, over a multi-year time frame. But given the state of the U.S. market and economy, while international diversification may be a sensible idea for most U.S. investors, its benefits are even more likely to accrue in the coming years.

The basic tenets of portfolio construction: diversification

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Diversify your portfolio for better risk-adjusted returns.

The asset correlation matrix above shows the correlation coefficients between Japanese equities, emerging markets, European stocks, and the S&P 500 (SPY) (VOO). The iShares MSCI Japan ETF (EWJ), the iShares MSCI Emerging Market ETF (EEM), and the iShares MSCI Europe ETF (IEV), respectively, serve as proxies. The matrix uses monthly returns for ten years.

From a portfolio diversification point of view, the correlation between two asset classes should be close to zero. A correlation coefficient of one means the two assets move together proportionately. A correlation of minus one means the two asset classes move in opposite directions.

As you can see, EWJ, EEM, and IEV give some diversification benefits each, if you are invested in the S&P 500 alone. The correlation between the S&P 500 and EWJ, EEM, and IEV is +0.66, +0.81, and 0.89, respectively. A diversified portfolio helps give better risk-adjusted returns. Also consider including bonds (AGG), which give better diversification benefits.

Read Pockets of Value in the Stock Market for more investment ideas.


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