by etienner
The case against a 100% S&P 500 ETF portfolio
A lot of investors have a 100% S&P 500 portfolio, especially in the United States. Over the long-term, a simple portfolio like the one mentioned above performed greatly over the past 50 years. However, I think it is possible for investors to have a diversified portfolio that has a lot less volatility with a similar (or even better) return. As the Nobel Prize winner Harry Markowitz said: “diversification is the only free lunch in investing”, and I believe it is true.
The assets I will use in the experiment are: US stocks, REITs, Gold, Long Term Treasuries and Small Cap stocks. The reason why I chose these is because they have a negative, low or medium correlation and they have a risk profile similar to stocks, that’s why I did not include Cash or Short Term bonds). Small Cap stocks have a high correlation to US stocks, but they can be used to increase the return of a diversified portfolio (I will come back to this later).
First of all, here is the correlation of all the assets mentioned above since 1994 : imgur.com/hkCGcIV
As you can see, except for Small Caps, all of the assets have a low to medium correlation to US stocks. Now, let’s compare US stocks to every asset in this portfolio and see if any of those could be a good addition to an investor’s portfolio.
Gold
Here’s what the risk/return profile of gold is compared to stocks since 1972 : imgur.com/OtnER6L
As you can see, gold both has a lower return and a higher volatility, so why would anyone want gold? Due to its low correlation to stocks, holding a small allocation to gold actually increases a portfolio’s return and reduces its volatility when rebalancing annually. In fact, a 80% stocks/20% gold portfolio had a return of 10.60% annually with a 12.97% volatility.
Long Term Treasuries
Long Term Treasuries is the asset with the lowest correlation to US stocks (-0.22), so it is one of the best diversifier an investor could have to reduce volatility. Here’s the risk/return profile for both asset since 1978 : imgur.com/KHpYvlL
Long Term Treasuries underperformed Stocks by 2.74% annually. However, its volatility is about 4% lower. So if we add a 20% Long Term Treasuries allocation to a Stock portfolio, what happens to our portfolio’s risk and return?
A 100% Stocks portfolio would have performed better than a diversified portfolio with both Stocks & Long Term Treasuries. In fact, the 100% Stocks portfolio returned 11.43% annually while the 80/20 portfolio returned 11.25%. However, the volatility is much lower for the 80/20 portfolio. It had a 12.41% volatility, while the Stocks portfolio had a 15.16% volatility.
REITs
Real Estate Investment Trusts (or REITs) have a medium-high correlation to US stocks (0.57 since 1994) and have a higher risk/return profile. I still included REITs in the analysis, because a small allocation to REITs still decrease a portfolio’s volatility. Here’s the risk/return profile for both assets : imgur.com/to6TBcX
As you can see, REITs both have a higher return and a higher volatility. However, once you combine both assets. The portfolio’s return increases to 9.70% and the volatility decreases to 14.34%. Below is a graph showing the difference in return between both assets (Stocks and REITs) and the diversified portfolio : imgur.com/0PHqVqQ
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Now, there are 3 assets that we know can help reduce a stock portfolio’s volatility and can sometimes even increase its return. But what if we invested in all of the assets mentioned above? For example, what if we had a portfolio that was 20% REITs, 20% Gold, 20% Long Term Treasuries and 40% Stocks?
As you can see, even though the return decreased by 0.38%, the volatility decreased by more than 5.45%. So even if you have high-risk tolerance, it can still be smart to diversify for two main reasons:
- The return of your portfolio won’t even be greatly affected in the long run
- You can take additional risk elsewhere (e.g. replacing US Stocks by Small Caps, Emerging Markets or Growth Stocks)
At the beginning of this article, I talked about Small Caps and their high correlation to US stocks. Obviously, Small Caps are a poor diversifier, but we can replace US stocks by Small Caps and increase the portfolio’s return. Adding a riskier asset with a high US Stocks correlation will obviously increase the portfolio’s volatility, but it will still be lower than if we had a 100% US stocks portfolio. Below is a table showing the risk/return profile of 4 different diversified portfolios by replacing US stocks for riskier assets : imgur.com/vHJDfUt
As you can see, even when we replace US stocks by asset classes with a higher volatility, the portfolio’s volatility is still at least 3% lower than a 100% Stocks portfolio. And when we replace US stocks by Micro Caps or Growth Stocks, the diversified portfolio outperformed a 100% Stocks portfolio with a much lower volatility.
To summarize, the different portfolio allocations mentioned above are the “free lunch” that diversification really is about and it possible to have a lot less volatility without sacrificing any return (we have seen that we can even increase a portfolio’s return with less risk). Obviously, we don’t know what asset class will outperform in the future, but this is only further reason why someone should not only have a S&P 500 ETF in its portfolio.
Disclaimer: Consult your financial professional before making any investment decision.