An Example of Scientific Diversification
May 26th, 2009Again, many thanks for following along. Tonight I’ll be brief, very brief, as I’m sure you’re tired and would like a break. With that said, I’ll provide you with an actual example of numbers I ran with data from DFA.
Consider two indexes, the S&P 500 and the MSCI Japan index (I believe MSCI stands for Morgan Stanley Composite Index, but don’t hold me to it). From January 1, 1970 through June 30, 2005 (I did the project in August of 2005) the S&P 500 had a geometric average annual return of 11.1 percent. Similarly, the MSCI Japan index had a geometric average annual return of 10.6 percent for the same period.
That’s return. What about risk? For the subject time period, the S&P 500 had 44 negative quarters, compared to 55 negative quarters for the MSCI Japan index.
What happens if you combine these two investments, with 60 percent going toward the S&P 500 and 40 percent going toward the MSCI Japan index? Logically, you’d expect a geometric average annual return of something between 10.6 percent and 11.1 percent, right? I mean, that’s only logical.
And as for risk, if you do the 60/40 combination you’d expect something between 44 and 55 negative quarters, right? Again, that’s only logical.
However, if you combine the two assets and run the numbers, you get a combined geometric average annual return of 11.6 percent, which is above either investment by itself (see bar chart below). Wow! That’s great! The combination is greater than the sum of its parts.
And what about risk? The combined portfolio has only 40 negative quarters, which is less than either portfolio on its own. LESS RISK, MORE RETURN! That’s what we want.
No,, this isn’t voodoo math. Rather, it’s a combination of statistical covariance and linear programming – for the investors’ benefit!
Stay tuned, as more good stuff is yet to come. We want to raise your return, reduce your risk and cut your costs.
Thanks,
Rod
Benefits of Portfolio Diversification
15 Responses to “An Example of Scientific Diversification”
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Interesting as always.
Thanks for the information
JC
JCMACKENZIE.COM
Making money-reviews
Hi Rod,
Thanks for a great example! That being said…I would prefer my money to be working a bit harder than 11% return
Duane
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Rod,
>
LESS RISK, MORE RETURN! …. it’s a combination of statistical covariance and linear programming – for the investors’ benefit!
>
Sounds great to me!
For today’s environment, 11% is a good return. As for the period covered in your study, it might not be so. But still, the lower level of volatility is a bonus.
John Ho
Numerology Expert Helps Understanding Personality for Better Influence & Persuasion (WordPress Blog)
Numerology Expert Daily Numeroscope (Vox Blog)
Numerology Expert Helps Understanding Personality for Better Influence & Persuasion (Money Page)
That is so helpful how you demonstrate, yes, what we would logically think without actually doing the math out like you do. And then how combining the two we would be reducing our risk while increasing our return. Superb.
Thanks for demonstrating that and making it more clear for our personal finances.
Best regards,
April Braswell
Single Boomer Dating Expert, Relationship Success Coach
Widow Support and Bereavement Counseling Outreach Workshop Henderson, NV, Nevada, Las Vegas
Fascinating stuff. I’m loving the graphs.
And loving the science!
JJ Jalopy.
Coaching Mentoring Expert JJ Jalopy
Less risk, more reward? Sign me up.
Christian Haller
Good Food Fast & Easy
Healthy Italian Recipes
very cool example. I want to learn more so I’ll keep reading.
Seize the Day,
Rob
Sales Expert For Small Business Owners
Personal Asset Protection For Small Business Owners
This is some powerful information. Thanks
Steve Chambers, The Sales Expert
The Sales Eagle Solution – 12 months to dominate your market
Very interesting, Rod! I think I can make sense of why a greater return might be had from the 60/40 split than from 100% in either index. However, I look forward to learning more from you about this.
Health, Fitness — Darryl Pace
Fitness Product Review
love the graphics.
Don Shepherd
Central Oregon Camphiker
Wow, once again, you deliver book like content in your blog. I dig the graphs.
Anthony
http://www.anthonylemme.com
The Most Powerful Personal Growth and Mind Development Tool on Earth
Darryl,
Good point on the 60/40 split. In down periods it will do better, but in bull periods it won’t do as well as the DFA Global Equity. The neat thing to see is that the lines aren’t as jagged up and down for the 60/40 as for the other investment options. Why? Because it’s lower risk (do you remember lower standard deviation?), it’s a smoother ride.
Also, although it’s significantly less risk than the S&P 500, it gets you to almost the same place, even with the higher fees. Why? It’s a more scientific, better designed investment than the S&P 500. But don’t knock the S&P 500, as it beats over 90 percent of its peer funds over a multi-year period. That shows just how good the DFA investments are.
Stay tuned, and keep the questions coming!
Thanks,
Rod
Christian,
Any advisor who’s worth his salt, and I admit we’re few and far between, should be able to bring you more return with less risk.
Stay tuned!
Thanks,
Rod
Duane,
Keep in mind what you’re comparing it to. This is a highly diversified global portfolio over a long period of time with no leverage and no personal oversight.
Stay tuned!
Thanks,
Rod
I like your use of the chart, it helps me to understand when I can visualize it like that.
Lisa McLellan, Babysitting Services – Babysitters, Nannies, and Au-pairs