Too often investors scrutinize their portfolio statements like tense parents reading a child's report card. They glaze over the A's and B-pluses and, with furrowed brows, hone in on that errant C.

In investing focusing too narrowly on a problem area often misses the big-picture story. It may seem counterintuitive, but investments that have underperformed their benchmarks or other

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holdings can actually improve the total risk/return profile over the long haul. This is not a new phenomenon, but it is one that investors routinely ignore. It's called the diversification effect. Remember diversification? (If not, get a refresher in Introduction To Diversification.)

Diversification Gets a Bad Rap
In the wake of the wild volatility in financial markets over the past few years, many investors have come to view with a jaundiced eye the notion that there is safety in spreading your bets. This reaction is understandable, even if misplaced. True, diversification within equities, as shown in Table 1 below, does not appear to have helped investors much over the past three years.

Table 1: Returns of selected equity indexes (data: Janauary 2007 to February 2010)

Data Series Annulized Return Total Return
S&P 500 -5.52% -16.46%
MSCI World Ex US -4.40% -13.27%
Russell 2000 -5.56% -16.57%

What went wrong? The problem with diversification is that it works wonderfully in smoothing out volatility, until it doesn't. The global financial crisis of 2008 was precisely one of the periods when the values of multiple asset classes tumbled simultaneously. The following year witnessed a broad-based appreciation in assets values on a similar scale. The result were staggeringly high correlations between asset classes, as shown in Table 2 below.

Table 2: Correlation between selected equity indexes (data: Janauary 2007 to February 2010)

Data Series S&P 500 MSCI World Ex US Russell 2000
S&P 500 1.00 - -
MSCI World Ex US 0.99 1.00 -
Russell 2000 0.99 0.97 1.00

Back to Basics
So has diversification stopped working?

To answer that question, it helps to consider the objective of portfolio diversification - namely, to maximize returns for a given level of risk. Though the equity index correlations in Table 2 above seem to cast doubt on the effectiveness of diversification, the analysis is limited by its narrow focus on equities. Diversifying internationally within stocks is beneficial over time, but its effects pale in comparison to the benefits earned by owning bonds, commodities and other asset classes.

If anything, the past few years have magnified the importance of diversification. In 2008 the S&P 500 lost 37% while long-term government bonds returned 26%. The following year the S&P 500 soared by 26% as long-term government bonds dropped by 15%.

As an investor, what should you own for the remainder of 2010? The correct answer is both asset classes. To illustrate the dangers of not being diversified, consider this: An investor who was solely in equities starting in 2003 would have seen five years worth of gains wiped out in 2008. Had that investor then panicked and moved completely into bonds in 2009, he or she would have missed out on one of the S&P 500's greatest years ever. The takeaway is that diversification not only reduces the risk and volatility associated with investing, but also has the potential to increase returns. How so? (Learn more about this in The Importance Of Diversification.)

A Whole Greater Than the Sum of Its Parts
Between January 1979 and December 2009 the S&P 500 had an annualized return of 11.5%. Over that period, five-year U.S. Treasury notes returned 8.2% a year. If an individual had invested 50% in each of these assets, the annualized return would be the weighted average between the two, or 9.94%, right?

Wrong. In reality if you had rebalanced that initial 50/50 portfolio at the beginning of each quarter to stay 50% invested in each of two indexes, you would have attained an annualized return of 10.19%. Those extra 0.25 percentage points of return are due to diversification. By holding multiple assets that don't move in precisely the same way, then systematically rebalancing them to buy depreciated assets and trim winners, an investor can create a portfolio with value greater than the sum of its parts. (Learn how to rebalance in Rebalance Your Portfolio To Stay On Track.)

This principle of diversification works in increasing returns and in reducing risk. In other words the potential annualized return on a diverse portfolio that's regularly rebalanced is greater than the simple weighted average of the returns of its components; the expected risk (as measured by standard deviation, which is a measure of volatility) is lower.

Let's look at what for many investors is a more realistic asset allocation: 60% equities and 40% fixed income. In this hypothetical scenario 20% of the portfolio is invested in domestic large-cap growth, 10% in domestic large-cap value, 20% in domestic small-cap value, 10% in international equities, 25% in five-year U.S. Treasury notes and 15% in domestic long-term corporate bonds. Table 3 below provides a summary of the annualized standard deviation and returns for each asset class, the weighted average risk and return and the total portfolio risk and return from January 1979 through December 2009.

The bottom two rows of the table clearly show that the return of the total portfolio (which, in this simulation, was rebalanced quarterly) exceeds the weighted average of the individual portfolio components. What's more, the portfolio risk (again measured by its standard deviation) is more than 3 percentage points per year lower than the weighted average. In fact the total portfolio outperforms the weighted average portfolio by more than 0.7 percentage points a year over the 31-year term.

Table 3: Return increase and risk reduction through diversification

Data Series Annualized Return Annualized Std Dev Portfolio Weights
Russell 1000 Growth Index 10.31% 17.79% 20%
Russell 1000 Value Index 11.97% 14.89% 10%
Russell 2000 Value Index 13.26% 17.44% 20%
MSCI World Ex U.S. 9.87% 17.29% 10%
Five-Year U.S. Treasury Notes 7.92% 5.96% 25%
Long-Term Corporate Bonds 8.86% 10.46% 15%
Weighted Average 10.21% 13.32% 100%
Total Portfolio 10.94% 10.06% 100%

Lessons for Investors
Investors should keep the effects of diversification in mind when deciding what assets to own. Suppose you were offered two investments to add to your portfolio - one you expect to return 9% and the other 8% annually. Most investors would choose the asset with the higher expected return. However, even if the assets perform as expected, the total portfolio may benefit more from the lower-yielding asset because it also has a lower correlation to the rest of their portfolio.

Ultimately the success of each portfolio "widget" can't be judged solely by looking at its individual benchmark-relative performance - or even by its performance vs. other widgets. Investors need to factor in correlations. The math needed to quantify this phenomenon is complex, but the takeaway is simple: You can't ignore the big picture.

If only the same were true of your kids' report cards.

Still feeling uninformed? Check out last week's business news highlights in Water Cooler Finance: Zombies File Taxes, Dead Bills Rise Again.

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