Morningstar Magazine - April/May 2015 - 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.

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