One of the most important concepts for investors to understand is the link between risk and return. Generally speaking, the greater the risk you’re willing to take, the higher you can expect your long-term returns to be, as long as you’re willing to accept more volatility along the way.
But is it possible to increase your returns without taking on more risk? The good news is the answer is Yes, and it’s all down to diversification.
Of course, the most important reason for diversifying is that it reduces concentration risk. But a benefit of diversification that many people aren’t aware of is that it also delivers more reliable investment outcomes.
Wei Dai, Senior Researcher at Dimensional Fund Advisors, recently conducted a study entitled How Diversification Impacts the Reliability of Outcomes. In the resulting white paper, she explained how having a diversified portfolio is critical to capturing the premiums associated with different factors.
Of course, outperformance cannot be guaranteed, but academics have demonstrated how, for example, over the long term, small-cap stocks usually outperform large-cap stocks, value stocks beat growth stocks, and stocks with high operating profitability outperform those with low profitability.
Capturing those premiums is more complicated than it may first appear. Just because, say, small-caps rise by 10% across the board in a particular, that doesn’t mean that every small-cap stock rises by the same amount. Indeed some may produce stellar returns, while others perform very poorly. Predicting, at any one time, which small-cap stocks are going to outperform is extremely difficult. Missing out on the stocks that perform best will mean that you don’t receive the full benefit of small-cap premium.
To make matters worse, taking a concentrated position also adds to turnover and cost, which in turn will further reduce your returns. The answer, then, is to diversify broadly, to stay invested and to avoid trying to time the market.
Wei Dai then went on to ask, How do different levels of diversification impact on the probability of outperformance?
Quantifying probabilities in investing is not an exact science, but the Dimensional study looked at the chances of a range of simulated US large-cap portfolios, with differing levels of diversification, outperforming the Russell 1000 Index, over different time periods. It calculated that a fund with 50 stocks in it had a 69% chance of outperforming the index over 10 years. The figure rose to 92% for a fund containing 500 stocks. But the Dimensional Adjusted Large Cap Equity Index, which includes the full large cap universe of 1,000 names, had a 96% chance of outperforming the Russell 1000 Index over ten years. In other words, the more diversified the portfolio, the greater the chance of outperformance, especially over longer time periods.
Another advantage of diversification, the study found, is that tracking error declines steadily as portfolios increase in size. Again, this enables the investor to capture the premiums they’re targeting in a more reliable way.
I recently interviewed Adam French, co-founder and CEO of Scalable Capital on this subject of risk and return. Like Dimensional, Scalable also lays great store by diversification. Interestingly though, as I explained in a recent post, Scalable also uses data and technology to actively manage risk, thereby maximising the benefits of diversification.
Adam explains how it works in this video:
ROBIN POWELL is the founder and editor of The Evidence-Based Investor. A freelance journalist, he runs Regis Media, a specialist content marketing consultancy for financial advice firms around the world. You can follow him on Twitter and on LinkedIn.
The Evidence-Based Investor is produced by Regis Media, a boutique provider of content and social media management to financial advice firms around the world. For more information, visit our website and YouTube channel, or email Sam Willet or Christina Waider.
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