Diversification is known as the cornerstone of successful investing. The logic is straightforward: by spreading your investments across multiple sectors, you can reduce the impact of poor performance in one area, creating a smoother overall return.
What is less widely appreciated, however, is the sheer unpredictability of returns within a diversified portfolio. While many investors assume a predictable hierarchy of performance: shares at the top, followed by property, bonds, and cash – the data shows an incredible degree of randomness year on year.
This unpredictability only solidifies the concept of diversification for the average investor. By allocating across distinct asset classes, your portfolio will be many times more resilient.
Returns Matrix
This analysis focuses on the performance of five key asset classes. The reference index being used as a proxy for the returns of these asset classes is also noted.
- Cash (Bloomberg AusBond Bank Bill Index)
- Bonds (FTSE Australian Government Bond Index)
- Real Estate (S&P/ASX 300 A-REIT Index)
- Australian Shares (S&P/ASX 200 Index)
- Global Shares (MSCI World ex Australia Index)
These asset classes represent a significant portion of the returns most Australians would experience in diversified portfolios, whether in superannuation funds or other investment portfolios.
The matrix below illustrates the annual returns of these asset classes since 1985, with each colour corresponding to a specific asset class and its performance for that year.
What stands out is the lack of any discernible long-term pattern or trend, reinforcing the idea of randomness.
Key Findings
- A-REITs (Australian Real Estate Investment Trusts) were the top-performing asset class in 25% of the years analysed.
- Cash and Bonds can be seen as the highest-returning asset class in 36% of the years. This shows how often defensive assets outperform their riskier counterparts.
- During the Global Financial Crisis (2008), Australian Government Bonds delivered a remarkable 20% return. They also led performance in 2010 and 2011, showing the muted recovery of risk-based assets post the GFC.
- Clearly noted is the dominance of Global Shares in the past 8 years. However, looking backward, high performance years were much more sporadic.
This data not only reinforces the importance of diversification, but also counters the recency bias so many of us hold.
For example, many investors today assume that Global Shares consistently outperform Australian Shares. Yet, prior to 2017, Australian Shares were more frequently the best performers, securing the top spot in nine years compared to Global Shares’ six.
Similarly, many investors continue to discount the importance of bonds in a portfolio. If one only looked at the past decade, this view would be justifiable. However, a look at the total dataset reveals that Bonds ranked among the top three performing asset classes in 18 out of the 40 years studied. This is nearly 50% of the time that bonds outpace at least one of the share options or property.
Cash also proves to be a good diversifier, ranking in the top three performers 17 times over the 40 years studied.
Diversified Portfolio Returns
To illustrate the practical benefits of diversification, a portfolio has been constructed using allocations to each of the asset classes outlined earlier.
This portfolio reflects a typical 70% Growth allocation, similar to the blend found in many retail and superannuation fund products. By applying the same matrix as before, with the total return of the diversified portfolio shown in grey, the advantages of diversification become evident.
Key Findings
- The portfolio achieved an average annual return of 10.81% over the data set.
- Across the entire period, there were only six years of negative returns, equating to an average expectation of a negative return just once every 6.7 years.
- Even in 2008, a year marked by disastrous performance in share and property assets, the portfolio’s total loss was limited to 17%.
Summary
Diversification is a straightforward yet powerful concept that is both easy to understand and implement. However, it’s human nature to be influenced by recent trends, often resulting in an over-allocation to assets that have experienced extended periods of outperformance. This behaviour can undermine the very purpose of diversification.
A prime example is the prevailing narrative that Australian Shares have become less relevant compared to Global Shares. Yet, the data tells a different story: Australian Shares have been among the top two performers more often than Global Shares (21 years versus 17 years). This highlights the importance of looking beyond recent history when crafting a portfolio.
Effective diversification isn’t just about spreading investments across a variety of asset classes either, it’s also about maintaining consistency in your allocation and a long-term view of returns. The tendency to chase performance or react to short-term trends can erode the long-term benefits of a diversified portfolio. To maximise the benefits of diversification, it’s crucial to stay disciplined and resist making adjustments based solely on recent performance. Doing so will ensure more stable outcomes over time.
