Deep Thoughts on Diversification

By Dan Bortolotti and Canadian Couch Potato on September 3, 2013
Estimated reading time: 4 minutes

Just shy of two years ago—in October 2011—I wrote a post that laid out the year-to-date returns for the Complete Couch Potato portfolio. If you can remember that far back, the third quarter of 2011 was truly ugly. The European debt crisis was all over the news, the US government’s credit rating was downgraded, and the global economic outlook was bleak. If you held a diversified portfolio, your equities were in the toilet, but you were saved by a solid performance from REITs and outstanding returns from bonds, especially real-return bonds. Overall, the portfolio experienced a small loss over the first nine months of the year:

January–September 2011	Ticker	%	Return
iShares S&P/TSX Composite	XIC	20%	-12.02%
Vanguard Total Stock Market	VTI	15%	-5.26%
Vanguard Total Int’l Stock Market	VXUS	15%	-13.82%
BMO Equal Weight REITs	ZRE	10%	5.77%
iShares DEX Real-Return Bond	XRB	10%	9.53%
iShares DEX Universe Bond	XBB	30%	7.20%
Total			-1.6%

Now let’s look at how the Couch Potato has performed so far in 2013. Here are the returns as of August 30:

January–August 2013	Ticker	%	YTD return
iShares S&P/TSX Composite	XIC	20%	3.2%
Vanguard Total Stock Market	VTI	15%	20.8%
Vanguard Total Int’l Stock Market	VXUS	15%	5.6%
BMO Equal Weight REITs	ZRE	10%	-10.5%
iShares DEX Real-Return Bond	XRB	10%	-10.5%
iShares DEX Universe Bond	XBB	30%	-2.1%
Total			1.9%

How’s that for an about-face? So far this year, equities are in the black, with the US leading the way with both a strong stock market and a rising currency. Meanwhile, REITs and bonds (especially real-return bonds) have been throttled by rising interest rates and are on track for a negative year. However, the portfolio as whole has enjoyed a modest gain so far this year.

The rest of the story

The smart-asses in the audience will look at these two periods and scoff that “you Couch Potatoes didn’t make any money.” But we haven’t accounted for the 15 months between these two samples—that is, October 2011 through December 2012. As it happens, equity markets rebounded shortly after I wrote that original post: 2011 finished with a modest 2.4% return for the Complete Couch Potato. And 2012 was a strong year for all asset classes, with the portfolio logging a solid 8.7%.

So if we take a longer view—and we are long-term investors, after all—the numbers look like this for the full 32 months. These returns are annualized, and they assume the portfolio was rebalanced on January 1 of both 2012 and 2013:

January 2011-August 2013	Ticker	%	Return
iShares S&P/TSX Composite	XIC	20%	0.6%
Vanguard Total Stock Market	VTI	15%	19.0%
Vanguard Total Int’l Stock Market	VXUS	15%	5.9%
BMO Equal Weight REITs	ZRE	10%	6.7%
iShares DEX Real-Return Bond	XRB	10%	2.8%
iShares DEX Universe Bond	XBB	30%	3.8%
Total (annualized)			5.9%

Sandwiched between two difficult periods was a long stretch where both stocks and bonds performed well. Ironically, that was when you probably felt best about holding a diversified portfolio. I say ironically because when all asset classes perform well, diversification isn’t all that important. After all, it would have been hard to lose money in 2012, even if you made a few dumb moves at the wrong time.

On the other hand, in 2011 and 2013, you probably questioned the whole idea of a multi-asset-class portfolio. During the European crisis holding 15% in international equities felt like fiddling while Rome (and Lisbon and Athens) burned. And today we’re wondering why we didn’t listen to the bond bears who have been growling for years.

Yet these were precisely the periods when you most needed diversification. It saved you from significant losses both times. It allowed to you avoid ill-timed tactical shifts that would have slaughtered your returns. And it kept you fully invested so you were able to reap all the rewards of late 2011 and 2012.

An investor’s prayer

And so my children, bow your heads and as we reflect on the virtues of diversification. I invite you to carry these verses in your wallet and read them during those difficult times of market turmoil.

Footprints On My Portfolio

One night I had a dream—
I dreamed I held a diversified portfolio
and across my spreadsheet flashed scenes from my investing life.
For each scene I noticed two sets of footprints:
one belonged to stocks and the other to bonds.

When the last scene flashed before me,
I looked at the graph of my portfolio’s performance.
I noticed that many times during my investing journey,
there was only one set of footprints.
I also noticed that this happened during the
most difficult bear markets.

This really bothered me and I questioned my advisor about it.
“You said that once I decided to diversify,
it would benefit me all the time.
But I have noticed that during the most difficult markets
there is only one set of footprints.
I don’t understand why in times when I needed it most,
diversification should leave me.”

Mt advisor replied, “My precious, precious client,
Diversification did not leave you
during those difficult periods.
When you saw only one set of footprints,
it was then that it carried you.”