Morningstar Magazine - April/May 2015 - (Page 79)

Investors Diversified Benchmark Portfolio Basic Benchmark Portfolio The Benefits of Diversification The return and risk advantages of a diversified portfolio are real, but not always apparent. Here's why it works. 1990 IN PR ACTICE Jeremy Stempien We are often asked by investors why we should bother with diversification, especially after a year like 2014-or for that matter three of the past four years. In those years, the S&P 500 (and a number of U.S. broad-market indexes) outperformed most diversified portfolios, such as risk-based or target-date funds. The diversification naysayers claim this proves diversification didn't work. But that argument misunderstands diversification (and performance measurement, for that matter). We don't invest in a vacuum, but in relation to many considerations besides return. Not the least of these considerations is risk. So, we diversify not to outperform an all-stock index, but to get better risk-adjusted return. Below, we'll share our thoughts on diversification and how we discuss diversification and performance with our institutional partners. The concept of diversification is that investors can improve their risk-return profile by investing in multiple investments versus concentrating the balance in a single investment. Diversification can simply mean adding stocks spread across many different sectors (or an equity mutual fund) to a portfolio of one or two stocks, but here we'll use it in a portfolio-construction context, or allocating across many asset classes representing both equity and fixed-income investments. 1991 1992 1993 1994 1995 $ 3.50 individual market indexes: the Russell 3000 Index, 3.00 representing U.S. equity; MSCI EAFE Index, 2.95 3.00 representing non-U.S. equity; and the Barclays U.S. 2.50 Aggregate Bond Index, representing fixed income. Although most investors can choose a series 2.00 of investments across different asset classes to diversify, professionally managed diversified 1.50 investments do much more. Decisions such as 1.00 which asset classes to invest in, what the 1996 allocation 1997 be1998 asset class, and 0.50 should to each 1999 adjusting that allocation over time are all aspects of managing a truly diversified portfolio in an appropriate manner. These are things that professional investment managers attempt to do. How Diversification Works The rationale behind why diversification can be beneficial is based on a number of factors, most notably that spreading one's exposure across multiple asset classes aims to improve the Diversified risk-based and target-date funds use Diversified Benchmark Portfolio Basic Benchmarkvariety of asset allocations depending on $ a Portfolio overall risk-return characteristics of a portfolio. Or the product and investment manager. Some series simply put, you can expect that for a given level 2.00 employ a strategy using a simple set of six or of risk, a diversified portfolio should outperform an 1.72 seven commonly used asset classes; others use a undiversified portfolio over the long term. complex set of more than 20 asset classes. For our 1.50 analysis, we created a more complex benchA "basic" benchmark of stocks and bonds makes 1.35 mark that contains 19 asset classes to represent for a better performance comparison than a single the asset allocation of professionally managed 1.00 asset-class benchmark, such as the S&P 500. This basic benchmark represents simple exposures multiasset-class portfolios available in the across three very broad areas of the market: market today.¹ These asset classes can be found U.S. equities, non-U.S. equities, and fixed income. industry 2008 products. 2009 the afore- 0.50 Both 2000 2001 2002 2003 2004 2005 in multiple2007 2006 These three areas of the market are represented by mentioned basic benchmark portfolio and our EXHIBIT 1 Diversified vs. Basic, Long Term Since 1980, the diversified portfolio significantly outperformed the basic portfolio. Diversified Benchmark Portfolio Basic Benchmark Portfolio $ 40.00 36.91 31.1830.00 20.00 10.00 1980 1990 2000 2010 2014 0 Source: Morningstar. 1 The 19 asset classes for the diversified benchmark portfolio are: U.S. large-cap growth equity, U.S. large-cap value equity, U.S. mid-cap growth equity, U.S. mid-cap value equity, U.S. small-cap growth equity, U.S. small-cap value equity, U.S. REITs, non-U.S. developed large-cap equity, non-U.S. developed small-cap equity, emerging-markets equity, U.S. long-term bonds, U.S. aggregate bonds, U.S. short-term bonds, U.S. mortgage bonds, U.S. TIPS, U.S. high-yield bonds, non-U.S. developed bonds, emerging-markets bonds, and cash. global.morningstar.com/Morningstarmagazine 79 http://global.morningstar.com/Morningstarmagazine

Table of Contents for the Digital Edition of Morningstar Magazine - April/May 2015

Contents

Morningstar Magazine - April/May 2015

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