Diversification in an investment portfolio is one of the chief means of reducing risk and volatility. While many investors are familiar with diversifying their portfolios by investing in different stocks or stock sectors, fewer are familiar with the benefits of diversification across different asset classes.
A fairly typical diversified portfolio that is invested across various asset classes consists of a mix of stocks and bonds. However, diversifying with a mix of equity investments and fixed-income investments, such as bonds, only covers part of the spectrum of available asset classes. Other asset classes include commodities, real estate, hedge fund and private equity investments, and foreign currency exchange.
Different asset classes, such as commodities, typically have a negative correlation with stocks, and therefore tend to outperform when stocks are underperforming. Learn more about the primary benefits of diversifying an investment portfolio between different asset classes.
Increasing the Advantage of Diversification and Further Reducing Risk
Diversifying between asset classes increases the overall advantage of diversification, which is that it reduces volatility and risk. One study of data from 1995 to 2014, conducted by a group of portfolio managers at Dundee Goodman Private Wealth, illustrates this point quite firmly. The study looked at an investment portfolio diversified simply with a mix of domestic, international and emerging markets stocks, as compared to a portfolio diversified across stocks, bonds and commodities, and found a significantly greater diversification advantage for the asset-class-diversified portfolio. The stocks-only portfolio, even though it was diversified internationally, provided only an 8.4% diversification advantage, while the portfolio that held diversified asset classes rendered a diversification advantage of approximately 45%, which was roughly five times better.
Obtaining Access to Potentially Higher Returns
In addition to reducing volatility and overall risk, a portfolio diversified between different asset classes can also potentially offer higher returns. The Dundee Goodman study found a 500% greater reduction in volatility (45% versus 8%) and found that the portfolio diversified with a variety of asset classes performed better, both in terms of overall investment returns and in a greatly reduced level of drawdown. Maximum drawdown refers to the maximum temporary percentage loss a portfolio has to endure over a period of time. The portfolio diversified across three asset classes showed an average annualized return of 9.46%, while the portfolio only diversified among different stock markets had an average annualized return of just 6.07%.
Even more dramatic was the advantage of the asset-class-diversified portfolio in regard to drawdown. The portfolio invested in different asset classes had a maximum drawdown of only 21%, while the stocks-only portfolio suffered a maximum drawdown of 59%.
Taking Advantage of Hot Assets
Asset classes, just like different market sectors in the stock market, tend to go in cycles. There's no way to know exactly when a certain asset class will become the next hot market offering investors superior returns. The overall U.S. stock market enjoyed a long bull market following the 2008 financial crisis, but in the later part of 2015 and the beginning of 2016, that bull run came to a screeching halt. The Standard & Poor's (S&P) 500 barely managed a 1% gain for the first quarter of 2016. Gold, which had been in a severe slump since 2013, took off in the first quarter of 2016, realizing a 20% gain. A portfolio that included gold would have experienced a much more satisfying opening part of the year than a stock-only portfolio.
One way to maximize profits is by taking advantage of investments within an asset class that typically have positive correlations. Oil and gold, for example, are commodities that often rise or fall in price simultaneously. An investor who is already profiting from a rise in gold prices might consider adding some investment in oil, with the hope that oil prices will also enjoy an upward surge.
An Easy Way to Diversify Across Asset Classes
The emergence of exchange-traded funds (ETFs) as a popular investment has made it relatively easy for investors to obtain exposure to asset classes that were previously extremely difficult, if not impossible, for the average retail investor to access. There are ETFs to suit virtually any desired asset allocation mix. Commodity and foreign currency ETFs offer exposure to the futures and currency markets, and there are also ETFs that invest using hedge fund strategies or invest in private equity firms. Reviewing ETFs in different asset classes offers investors a much wider choice of investments and better opportunities to optimize their total portfolio.