Most investors know diversification is an essential piece of planning their portfolio. If you diversify across asset classes properly, you can maximize your returns for your risk tolerance.
Many investors stick with basic portfolio allocations like 60% stocks, 40% bonds because someone told them that's a good balance. But if you want to understand diversification and why a 60/40 stock-to-bond ratio might make sense, be sure to check out the chart below.
How to get greater returns without increasing risk
Let's say you wanted to get a relatively safe return on your investment, but still get your money working for you. You might think investing all of your money in U.S. treasury bonds is the best way to do that. After all, if the U.S. government defaults on its debt, you probably have bigger things to worry about than going broke.
Actually, investing all your money in treasury bonds carries more risks than splitting it up between Treasury bonds and a U.S. stock market index fund like the Vanguard Total Stock Market Index Fund ETF (VTI -0.63%). What's more, you'll be able to see greater returns for the same level of risk with proper diversification across the two assets.
The above chart depicts the efficient frontier for a two-asset portfolio consisting of Vanguard's U.S. stock market index fund and the iShares 20 Plus Year Treasury Bond ETF (TLT -0.58%). The chart is based on data from the past 20 years, not future projections.
The efficient frontier is part of Harry Markowitz's Modern Portfolio Theory, which won him a Nobel Prize in economics. It depicts the best possible return for any given level of variance in portfolio returns.
The left edge of the chart shows the asset allocation that minimizes risk -- at about 44% stocks and 56% bonds. The bottom of the chart shows the risk return profile of investing 100% in the iShares bond ETF. But if you move vertically on that chart to the point above it on the efficient frontier, you can find a portfolio with the same risk profile, but greater expected return -- about 88% stocks and 12% bonds. The latter portfolio also historically returns over 4% more per year on average.
What makes this possible?
The factor that makes it possible to decrease the volatility of your portfolio while increasing returns is the price correlation between asset classes. The prices of the stock and bond ETFs above have a correlation around -0.32. That negative correlation implies that when the stock fund increases in value, the Treasury bond fund decreases in value, and vice versa.
So, while stocks are more volatile than bonds, adding some stocks to a bond portfolio will make the overall volatility decrease because the two assets generally move in opposite directions.
To truly diversify, you want to invest across asset classes with a low correlation to one another. They won't all have negative price correlations, like stocks and Treasury bills, but some will and others may have no correlation at all. For instance, correlations between large-cap stocks and small-cap stocks are fairly high, but there's almost no correlation between stocks and gold prices.
You'll also need a forecast for expected returns for each asset class (or historical returns) and the standard deviation of those returns. Using those combined with price correlation can help you graph the expected return and variance of sample portfolios.
Optimizing a two-fund portfolio just requires a simple spreadsheet. As you expand into four or more asset classes, you can use software to solve for and minimize portfolio variance, based on past history.
Become a smarter investor
It's one thing to understand why you should diversify your portfolio, it's another to understand how diversifying across asset classes actually impacts your risk and return profiles.
If you can understand the chart above, you may be able to shift more of your portfolio into assets with higher expected returns while keeping your portfolio's volatility stable.
Likewise, when you start adjusting your portfolio balance as you approach retirement, you'll be able to find a portfolio that minimizes variance while maximizing expected returns, so you can rest assured your portfolio is about as safe as can be.