Israelsen on Diversification (Part 2)

Today I continue with some “words of wisdom” written by Craig Israelsen in the Feb 2016 issue of Financial Planning magazine.

     > Interestingly, many investors claim to want a low-
     > correlation portfolio that includes ingredients that
     > do not all zig and zag at the same time. But when a
     > few of their portfolio ingredients zag downward
     > while other portfolio ingredients are zigging upward,
     > the investor frets about the underperforming zaggers
     > and becomes angry he owns a fund or stock that is
     > losing money.
     >
     > Many investors talk the talk, saying that they want
     > a low-correlation portfolio, but they can’t—or
     > won’t—walk the walk and actually experience one.

As mentioned a couple times in the last post, I completely agree on an anecdotal level based on what I have heard from multiple investors during casual discussion.

Israelsen continued by providing data for different “levels of diversification” over the last 15 years. He looked at a 1-, 2-, 4-, 7-, and 12-asset portfolio. The 1-asset portfolio was 100% U.S. large-cap stocks. The 4-asset portfolio was 40% U.S. large cap, 20% U.S. small cap, 30% bonds, and 10% cash. The 12-asset portfolio was equally divided into 12 different asset classes. Annualized performance through 11/30/15:

I highlighted the best (worst) performance for each column in green (red).

Israelsen writes:

     > Over the three-year, five-year, and 10-year periods…
     > the one-asset class investment… was the best
     > performer. Finally, over the 15-year period, the
     > value of a broadly diversified approach manifested
     > itself with an annualized return of 7.08%…

If you’re a believer in diversification then this sounds like it took 15 years for the noise to shake out and the truth of diversified superiority to become evident.

However, from a statistical standpoint I doubt these numbers prove anything. The 12-asset portfolio performed worst over one, three, and five years. I believe one year is too short to conclude anything. 3-5 years, though? That’s at least intermediate-term. I would consider 10 years to be long-term and the 12-asset portfolio performed second worst over this interval. Given that it performed best over 15 years, I believe we have a set of performance numbers that, considered altogether, are inconclusive.

I also don’t think 15 years tells the whole story. I wonder what portfolio outperformed over 13, 14, 16, or 17 years? If it’s the 12-asset portfolio then Israelsen’s claims are substantiated. Based on the trend of numbers presented, though, I would not be surprised to see a more scattered distribution.

Israelsen writes:

     > …a broadly diversified approach will lag behind
     > when one particular asset class… is on a hot streak.

I don’t like this as a caveat for why the 12-asset portfolio lagged in all but the 15-year time interval. Some asset class is always going to be on a hot streak, which would suggest a broadly diversified approach will always lag. So if you want to choose a loser, make sure to diversify? That’s certainly what it can feel like and this feeds right back to the Israelsen excerpt at the top of this post.