Investors often have a hindsight bias when reviewing their investments: “If only I had put all my money in this stock that doubled in value.” People instinctively want to invest in the most profitable asset class. And “diversification” in many people’s minds means low risk and low return.

However, research data shows that diversifying asset classes can not only reduce risk, but also increase returns. This may sound counterintuitive, but this issue of Poseidon Market Watch will analyze the principles and challenges behind this argument.

Summary

• Diversifying asset classes is a strategy of allocating a portfolio across different types of assets, such as stocks, bonds, real estate, commodities, etc.
• The purpose of this strategy is to improve the overall performance of the portfolio by diversifying risk and compensating for each other among assets.
• Diversifying asset classes is widely regarded as an effective investment strategy, using the low correlation between different assets to reduce overall volatility and increase long-term returns.
• In the long run, diversified asset class portfolios can achieve the average return rate of various asset classes, which is often higher than the return rate of single asset class portfolios.
• Adjusting the portfolio according to a certain time interval or weight deviation can help us maintain the risk and return characteristics of the portfolio and achieve the effect of buying low and selling high.

Comparison of 15 Portfolios

Diversifying asset classes is regarded as an effective investment strategy, and some people also describe it as “the only free lunch”. Simply put, you can allocate different types of assets in a portfolio, such as stocks, bonds, real estate, commodities, etc. Using the low correlation between different assets to reduce overall volatility and increase long-term returns.

This sounds simple, but it actually requires a lot of data analysis and strategy design. Here is a specific example.

The above figure compares the performance of 15 different stock portfolios in the 34 years from 1972 to 2005: two dimensions of performance: volatility (standard deviation) and return (annualized return rate).

These 15 portfolios are:

• Single asset class portfolios: US stocks (A), non-US stocks (B), real estate securities ©, commodity-related securities (D)
• Two asset class portfolios: AB, AC, AD, BC, BD, CD
• Three asset class portfolios: ABC, ABD, ACD, BCD
• Four asset class portfolios: ABCD

The diversified asset class portfolios are evenly distributed and rebalanced annually.From the figure, it can be seen that diversified asset class portfolios (triangles, diamonds and circles) are generally better than single asset class portfolios (squares), because they can concentrate in the lower right area (low volatility and high return), while single asset class portfolios are scattered in the upper left area (high volatility and low return).

This means that diversified asset class portfolios can provide higher risk-adjusted returns, which is the Sharpe ratio. It is measured by dividing excess returns by volatility to measure the returns obtained per unit of risk.

Investors in the market will allocate their funds to different asset classes according to their own risk preferences and expected returns, so that the prices of various asset classes reach a balance between supply and demand.In the long run, diversified asset class portfolios can achieve the average return rate of various asset classes, which is often higher than the return rate of single asset class portfolios.

Challenges of Diversifying Asset Classes

The above case is a relatively ideal analysis. In actual implementation process, there will also be some challenges: how to choose suitable asset classes, how to determine reasonable weights, how to deal with psychological biases and pressures, etc., which will affect the performance of the portfolio.

Asset Class Selection

Different asset classes have different risk and return characteristics. In addition to this, they also need to choose suitable asset classes according to their investment objectives and risk preferences.

As shown in the figure below, if investors currently hold all A (US stocks) in their portfolio and need to choose another asset class to increase their position.

If you know the relationship between risk and return in the figure below, then it seems that most people will choose C (real estate securities) without hesitation, because it has the lowest volatility and highest return.

But the blind spot is that the correlation between these asset classes is unknown. The correlation between most asset classes is positive, and negative correlation cases are very rare.

As shown in the figure above, the result is different from the first subjective impression: the portfolio of A (US stocks) and D (commodity-related securities) has a higher Sharpe ratio, while C (real estate securities), which performed well in single asset classes, is not the best choice.

Investors should avoid choosing highly correlated asset classes, so as not to reduce the diversification effect of the portfolio.

It is worth noting that correlation is not constant, and the correlation between different asset classes will also change over time.

Allocation Ratio

After choosing suitable asset classes, you also need to decide how to allocate funds to each asset class. There is no fixed answer to this question, because different investors may have different preferences and goals.

Based on mathematical models and historical data to optimize portfolio efficiency, you can help us find the portfolio that can achieve the highest expected return rate at a given risk level, or the lowest risk at a given expected return rate: calculate the expected return rate, volatility and correlation of different asset classes, and use some optimization algorithms to solve the optimal weight.

You can also allocate funds based on fundamental analysis and historical experience, by observing and predicting the market and economic environment to adjust the portfolio.

Rebalancing Frequency

Regular adjustment: Adjusting the portfolio according to a certain time interval or weight deviation can help us maintain the risk and return characteristics of the portfolio and achieve the effect of buying low and selling high. This method helps to simplify the decision-making process and reduce emotional interference, but it also has some drawbacks, such as regular rebalancing may miss some market trends or reversals, rebalancing frequency and threshold may not be suitable for current market conditions, rebalancing costs and taxes may affect portfolio performance, etc.

Dynamic adjustment: This is a method of adjusting the portfolio according to changes in market and economic environment. It can help us allocate more funds to better performing asset classes, and timely change the risk and return characteristics of the portfolio. This method helps to improve portfolio returns and adaptability, but it requires accurate and timely judgment of market and economic environment, adjustment frequency and amplitude may be too high or too low, judgment and decision-making are more susceptible to market noise.

The above figure is a statistical measurement of rebalancing frequency. Assuming that the arithmetic average return rate is 8.33%, the geometric average return rate is zero, and the transaction cost is zero, as the rebalancing frequency gradually increases, the return rate will decrease and approach a level. In actual situations, due to the existence of transaction costs, the return rate will be lower than shown in the figure. Therefore, from a statistical point of view, appropriate low-frequency rebalancing is conducive to the overall return level.

Investment Ideas and Suggestions

In addition to investing in indices to achieve diversification within a single asset class, investors should also allocate funds among different asset classes, such as stocks, bonds, real estate, commodities, physical gold, etc.

Choose low-fee ETFs for index investing or participate through other structured instruments to create additional returns.