uploads///Diversification Reduces Your Portfolios Risk

How Moving Away from the 60/40 Portfolio Improves Returns


Aug. 23 2016, Published 4:11 p.m. ET

Deceptively 60/40

While the alternative portfolio is still technically 60/40, the characteristics are somewhat different. First, expected risk (in other words, standard deviation – the measure of how dispersed returns are around the average) is lower by around 100 basis points, 7.70% versus 8.65%. In addition, the expected yield on the alternative portfolio, which includes both interest from the bond portion of the portfolio as well as dividends, is roughly 65 basis points higher. Finally, despite a static 40% weight to bonds and the introduction of more “defensive” equity positions, the duration, or rate sensitivity, is lower. The result is a less volatile, higher yielding portfolio that should be somewhat less vulnerable to a rise in interest rates.

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Market Realist: Reduce duration while diversifying your portfolio

The graph above shows the correlation between the iShares MSCI U.S. Minimum Volatility ETF (USMV), the SPDR S&P 500 ETF (SPY), the iShares Barclays Aggregate Bond ETF (AGG), the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), and the iShares S&P US Preferred Stock Index ETF (PFF) over the last four years.

While USMV and HYG have a high positive correlation with SPY, PFF has a mild positive correlation with all other ETFs, thereby adding diversification benefits. In other words, it improves risk-adjusted returns. Preferred shares also help improve the yield on a portfolio, while not increasing the risk by too much.

Meanwhile, high-yield bonds provide higher yields to a portfolio. Minimum volatility stocks provide some cushion when equities fall.

You can further diversify your portfolio by adding a small amount of alternative assets such as gold (IAU). Historically, gold has had low correlation with bonds as well as stocks. In the next part, we’ll discuss the flaws of a tweaked portfolio.


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