Diversification and increased returns

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Diversification and increased returns

Postby Streptococcus » Fri Apr 05, 2013 2:49 pm

Hello bogleheads,

Your infinite wisdom is once again required.

Let's say you have a 3 fund lazy portfolio and you want to add 2 funds to increase DIVERSIFICATION and POTENTIAL RETURN, and you want to choose 2 of the following 3: reit index, small cap value and emerging market index.

Which 2 would you choose and why?
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Re: Diversification and increased returns

Postby hlfo718 » Fri Apr 05, 2013 2:52 pm

Why can't you add all three?
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Re: Diversification and increased returns

Postby G-Money » Fri Apr 05, 2013 3:06 pm

Depends on your definition of "diversification."

If you mean diversification in the sense of efficiently spreading your investment over a collection of securities, then TSM and TISM may be all you need. One could very coherently argue that TSM and TISM are perfectly diversified, in the sense that your money is invested exactly the same as the market (see John Norstad's page: http://www.norstad.org/finance/total.html). Any deviation away from TSM and TISM would result in a concentration of some particular securities at the expense of others.

If you mean diversification in the French-Fama sense (i.e., diversification of risk-factors, as opposed to of securities), then you'd want exposure to small and value.

If you mean diversification in the sense of naive diversification, then you'd want more exposure to small cap or equal-weighted index funds.

If you mean diversification in the sense of increased Sharpe ratios or lower correlation to US or International markets as seen through backtesting, then nearly anything could fit that bill, and SV, REIT, and Emerging Market funds are popular choices.

So you need to define what you mean by "increase diversification" before you can get meaningful answers. And once you define the term, you may end up answering the question yourself. :)

In the interests of full disclosure, I tilt toward REIT and SV, but do not tilt Emerging Markets.
Last edited by G-Money on Fri Apr 05, 2013 3:10 pm, edited 1 time in total.
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Re: Diversification and increased returns

Postby Streptococcus » Fri Apr 05, 2013 3:10 pm

There is not enough space in our roth IRA (wife and mine).
AA is 42% domestic equities and 30% international and I want to allocate 7% to our tilters. The 7% is the $5500 roth ira max. 2 roth IRA for 2 tilters. I dont have space in my 403b and I dont want to put tax inefficient assets in my taxable.
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Re: Diversification and increased returns

Postby Streptococcus » Fri Apr 05, 2013 3:14 pm

G-Money wrote:If you mean diversification in the sense of increased Sharpe ratios or lower correlation to US or International markets as seen through backtesting, then nearly anything could fit that bill, and SV, REIT, and Emerging Market funds are popular choices.

That's what I mean; I want a more efficient portfolio, increase the return potential while controling the risk
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Re: Diversification and increased returns

Postby Clearly_Irrational » Fri Apr 05, 2013 3:21 pm

So run the math then come back and tell us the results?
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Re: Diversification and increased returns

Postby richard » Fri Apr 05, 2013 3:42 pm

G-Money wrote:If you mean diversification in the French-Fama sense (i.e., diversification of risk-factors, as opposed to of securities), then you'd want exposure to small and value.

Fama and French don't endorse diversification "in the French-Fama sense." Some people who claim to follow their research favor this, but I don't see any evidence they do.
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Re: Diversification and increased returns

Postby richard » Fri Apr 05, 2013 3:46 pm

Streptococcus wrote:That's what I mean; I want a more efficient portfolio, increase the return potential while controling the risk

You can't get a more efficient portfolio, presuming you're starting with a standard 3 fund portfolio, such as total stock market, total international and total bond. Any increase in potential returns will mean an increase in risk. As Fama said, the market portfolio is always on the efficient frontier. All you can do is increase risk in the hope of higher returns.

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Re: Diversification and increased returns

Postby Streptococcus » Fri Apr 05, 2013 3:51 pm

richard wrote:You can't get a more efficient portfolio, presuming you're starting with a standard 3 fund portfolio, such as total stock market, total international and total bond. Any increase in potential returns will mean an increase in risk. As Fama said, the market portfolio is always on the efficient frontier. All you can do is increase risk in the hope of higher returns.


I understand. The question remains: seeking diversification (in a sense of lower correlation) and potential higher return, which 2 of the 3 would you choose between small cap value, REIT and emerging market?
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Re: Diversification and increased returns

Postby InvestorNewb » Fri Apr 05, 2013 3:52 pm

I would choose REIT since its an asset class of its own.
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Re: Diversification and increased returns

Postby G-Money » Fri Apr 05, 2013 3:55 pm

richard wrote:
G-Money wrote:If you mean diversification in the French-Fama sense (i.e., diversification of risk-factors, as opposed to of securities), then you'd want exposure to small and value.

Fama and French don't endorse diversification "in the French-Fama sense." Some people who claim to follow their research favor this, but I don't see any evidence they do.

By "in the French-Fama sense," I merely meant that F-F have identified different risk-factors in the equity markets. I did not mean to suggest Fama or French endorse any particular kind of investing. Mea culpa if I was not sufficiently precise.
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Re: Diversification and increased returns

Postby G-Money » Fri Apr 05, 2013 3:59 pm

Streptococcus wrote:
G-Money wrote:If you mean diversification in the sense of increased Sharpe ratios or lower correlation to US or International markets as seen through backtesting, then nearly anything could fit that bill, and SV, REIT, and Emerging Market funds are popular choices.

That's what I mean; I want a more efficient portfolio, increase the return potential while controling the risk

In that case, you're aiming for a moving target. Sharpe ratios bounce all over the place. Correlations bounce all over the place. The whole "past performance is no guarantee of future results" bit doesn't just refer to the return side of things.
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Re: Diversification and increased returns

Postby Clearly_Irrational » Fri Apr 05, 2013 3:59 pm

richard wrote:You can't get a more efficient portfolio, presuming you're starting with a standard 3 fund portfolio, such as total stock market, total international and total bond.


Although it's quibbling over small details that statement is false. An "efficient" portfolio in this sense is one which has the highest expected return for the lowest volatility thus being on the two dimensional efficient frontier. While it would be more complicated, it would certainly be possible to create a portfolio that is more "efficient" than the standard three fund portfolio. In addition, depending on your forecast methods the normal market indexes may not be the most "efficient" choices in this context. For most practical purposes however you can ignore everything I just said and treat your answer as correct.
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Re: Diversification and increased returns

Postby kenyan » Fri Apr 05, 2013 4:06 pm

I overweight SV and REIT, but not Emerging Markets. I don't think this means my portfolio is more diversified, but obviously you've had enough responses already picking that remark apart, so I don't feel the need to pile on.

In terms of correlation, REITs will likely be the least correlated to the rest of your portfolio from those choices.
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Re: Diversification and increased returns

Postby Rick Ferri » Fri Apr 05, 2013 4:14 pm

kenyan wrote:I overweight SV and REIT, but not Emerging Markets.


I agree with that analysis.

kenyan wrote:In terms of correlation, REITs will likely be the least correlated to the rest of your portfolio from those choices.


At times this is correct, at times it is not. At times both will be highly correlated, at times both with be less correlated, and at times one will be highly correlated and the other less correlated. That's the whole idea behind diversification.

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Re: Diversification and increased returns

Postby EDN » Fri Apr 05, 2013 4:18 pm

Streptococcus wrote:Hello bogleheads,

Your infinite wisdom is once again required.

Let's say you have a 3 fund lazy portfolio and you want to add 2 funds to increase DIVERSIFICATION and POTENTIAL RETURN, and you want to choose 2 of the following 3: reit index, small cap value and emerging market index.

Which 2 would you choose and why?
Strep


In this order:

Small Value
We know that stock returns are a function of 3 factors -- exposure to the market, size, and value. A small value index gives you greater than market exposure to both small and value dimensions of expected return. These returns are different than that of the overall market. So by spreading your assets across multiple sources of unique risk, you are diversifying the risk/return of your portfolio (instead of just putting everything in a market portfolio with no additional exposure to small or value). That's a no-brainer.

REITS
Real estate investment trusts are a reasonable proxy for the returns of commercial real estate, and therefore behave differently than the general stock market. Are REIT returns expected to be higher or lower than the market? Who knows, unlike size and value factors, there is no "REIT factor", so we are just guessing here. Could increase your returns, could decrease them, its anyone's guess. The return ambiguity is an issue, the tax inefficiency is an issue, and if you own Vanguard SV, you already have a decent amount or REITs. So REITs aren't optimal

Emerging Markets
They don't really provide diversification, just much higher (than developed) risk, and probably return. EM is a different beast than developed non-US, so I'm not saying there is no diversification benefits, but it is just tough to measure given the extreme volatility and very short historical return history. So more EM is less about diversification and more about just higher returns, similar to just ratcheting up stocks vs. bonds

If I had to pick 2, the other wouldn't be either. I'd own Int'l and EM ("World exUS") Int'l small cap. Similar to the SV story above, without the value, but with the added help of non-US stocks. Historically, ISC has had high returns and offered nice diversification to a portfolio of US and Int'l LC stocks (which is what TSM portfolios are).

So if I was 60% TSM, 40% TISM, I'd go 40% TSM, 20% SV, 20% TISM, 20% TWorld exUS SC. If that was too risky, I'd add bonds, and know I could use the short-term stuff (lower risk) without hurting my overall portfolio return (because S/SV increases expected returns sufficiently on the stock side). So similar (or higher) expected returns as just TSM, TISM, and TBM, without increased risk thanks to the help of Modern Portfolio Theory and asset pricing research into the sources of risk/return.

Eric
Last edited by EDN on Fri Apr 05, 2013 4:21 pm, edited 1 time in total.
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Re: Diversification and increased returns

Postby richard » Fri Apr 05, 2013 4:20 pm

Clearly_Irrational wrote:
richard wrote:You can't get a more efficient portfolio, presuming you're starting with a standard 3 fund portfolio, such as total stock market, total international and total bond.

Although it's quibbling over small details that statement is false. An "efficient" portfolio in this sense is one which has the highest expected return for the lowest volatility thus being on the two dimensional efficient frontier. While it would be more complicated, it would certainly be possible to create a portfolio that is more "efficient" than the standard three fund portfolio. In addition, depending on your forecast methods the normal market indexes may not be the most "efficient" choices in this context. For most practical purposes however you can ignore everything I just said and treat your answer as correct.

We're living in a multi-factor world. The two-factor model, in which risk is defined as volatility, is outmoded.

Here's a good paper by Fama's colleague at Chicago (and son-in-law) http://www.chicagofed.org/digital_asset ... 3Q99_4.pdf
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Re: Diversification and increased returns

Postby Clearly_Irrational » Fri Apr 05, 2013 5:12 pm

richard wrote:We're living in a multi-factor world. The two-factor model, in which risk is defined as volatility, is outmoded.

Here's a good paper by Fama's colleague at Chicago (and son-in-law) http://www.chicagofed.org/digital_asset ... 3Q99_4.pdf


I'm well aware of multi-factor models and in fact make use of them myself. That said "risk" and "risk factors" are not the same thing.

Frankly I think volatility is a poor measure of "risk" as most normal people would define it. I tend to use a distribution curve model with my goal being to have a short, thin left tail.
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Re: Diversification and increased returns

Postby Streptococcus » Fri Apr 05, 2013 6:14 pm

EDN wrote:In this order:

Small Value
We know that stock returns are a function of 3 factors -- exposure to the market, size, and value. A small value index gives you greater than market exposure to both small and value dimensions of expected return. These returns are different than that of the overall market. So by spreading your assets across multiple sources of unique risk, you are diversifying the risk/return of your portfolio (instead of just putting everything in a market portfolio with no additional exposure to small or value). That's a no-brainer.

REITS
Real estate investment trusts are a reasonable proxy for the returns of commercial real estate, and therefore behave differently than the general stock market. Are REIT returns expected to be higher or lower than the market? Who knows, unlike size and value factors, there is no "REIT factor", so we are just guessing here. Could increase your returns, could decrease them, its anyone's guess. The return ambiguity is an issue, the tax inefficiency is an issue, and if you own Vanguard SV, you already have a decent amount or REITs. So REITs aren't optimal

Emerging Markets
They don't really provide diversification, just much higher (than developed) risk, and probably return. EM is a different beast than developed non-US, so I'm not saying there is no diversification benefits, but it is just tough to measure given the extreme volatility and very short historical return history. So more EM is less about diversification and more about just higher returns, similar to just ratcheting up stocks vs. bonds

If I had to pick 2, the other wouldn't be either. I'd own Int'l and EM ("World exUS") Int'l small cap. Similar to the SV story above, without the value, but with the added help of non-US stocks. Historically, ISC has had high returns and offered nice diversification to a portfolio of US and Int'l LC stocks (which is what TSM portfolios are).

So if I was 60% TSM, 40% TISM, I'd go 40% TSM, 20% SV, 20% TISM, 20% TWorld exUS SC. If that was too risky, I'd add bonds, and know I could use the short-term stuff (lower risk) without hurting my overall portfolio return (because S/SV increases expected returns sufficiently on the stock side). So similar (or higher) expected returns as just TSM, TISM, and TBM, without increased risk thanks to the help of Modern Portfolio Theory and asset pricing research into the sources of risk/return.

Eric


Eric, your input was very much appreciated; thanks


Rick Ferri wrote:kenyan wrote:
I overweight SV and REIT, but not Emerging Markets.

I agree with that analysis.

kenyan wrote:
In terms of correlation, REITs will likely be the least correlated to the rest of your portfolio from those choices.

At times this is correct, at times it is not. At times both will be highly correlated, at times both with be less correlated, and at times one will be highly correlated and the other less correlated. That's the whole idea behind diversification.

Rick Ferri


Love to have a reply from Rick Ferri. I'm a huge fan :happy
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Re: Diversification and increased returns

Postby truenorth418 » Fri Apr 05, 2013 6:27 pm

Roger Gibson, in his book "asset Allocation - Balancing Financial RIsk", showed that adding REIT and commodities to a portfolio produced higher returns with less volatility. I personally haven't added commodities but I have over-weighted REITs for now and also added some emerging.
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Re: Diversification and increased returns

Postby Clearly_Irrational » Fri Apr 05, 2013 7:13 pm

truenorth418 wrote:Roger Gibson, in his book "asset Allocation - Balancing Financial RIsk", showed that adding REIT and commodities to a portfolio produced higher returns with less volatility. I personally haven't added commodities but I have over-weighted REITs for now and also added some emerging.


I did a lot of modeling with commodities and in general I found them to be too pro-cyclical to produce the kind of results I wanted. Futures contracts do seem to deliver some diversification, but the ETF versions don't seem to be able to capture that very well. After sorting through all of it, gold (and to some extent other precious metals like silver & platinum) was the only portion that seemed to have a good effect when used appropriately.

REITs are so so, but I find that direct exposure produces more of the benefits I wanted, with an obvious cost of being slightly less passive.
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Re: Diversification and increased returns

Postby staythecourse » Fri Apr 05, 2013 10:54 pm

It would seem the OP is asking about maximizing "diversification return" as Booth talks about from DFA fame. This is the process where the portfolio's returns are more then the weighted average returns of each asset in the portfolio.

The two main determinates of maximizing diversification return is to maximize: Volatility and low correlations.

I think the real advantage (and will likely see more articles written about in the future) is the use of beta, small, and value to maximize diversification return as they have high volatility and low correlaton.

The answer then would seem to be SCV and then REITS.

Good luck.

p.s. I would second Gibson's book as mentioned above as one of the finest books written that isn't mentioned much on this site.
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