Diversification provides many benefits for investors. Not only can we increase the expected return for a given level of risk, but we can also increase the reliability of capturing premiums or “dimensions” of expected return. In other words, once we decide that we want our portfolio to have a tilt towards stocks that are small, value, and profitable, a decision has to be made about how to best go after these premiums.
One approach would be to have a portfolio that is highly concentrated. We only want the smallest and value oriented stocks. Another approach would to take a more diversified approach, spreading our net around thousands of securities and slightly biasing towards those that best fit the dimensions we are seeking.
Because we do not know which securities are going to outperform (we cannot predict the future) over any given time period, we do not know which securities are going to contribute to a particular premium. For example, the small cap premium may be realized, but in reality there may be only a small subset of small cap stocks that contributed to that realized return. Maybe it was a particular company, sector, or region that drove that performance. Again, because we cannot know for sure in advance, taking a broad approach to targeting premiums is prudent. Taking a more concentrated approach creates the risk of excluding certain holdings that were responsible for delivering that particular premium over that time period.
A recent research paper published by Dimensional Fund Advisors shows the importance of diversification in action. Using stocks solely found in the Russell 1000 Index from July 1979 to June 2016, they create 4 different simulated portfolios that have the same tilts towards small, value, and profitability premiums, but are different in terms of the amount of securities they hold. The 4 simulated portfolios include 50, 200, 500, and over 1,000 individual securities. Again, the question we are trying to answer is “how much more reliable is the 1,000 security portfolio at capturing return premiums versus the more concentrated 50 security portfolio?”
The chart below shows the results over 1, 5, and 10 year periods between July 1979 and June 2016.
As you can see, across each time period, there was a consistent increase in the probability of capturing return premiums as the number of securities increased. We also see there was a consistent increase in the probability of capturing return premiums across all 4 simulated portfolios as the time period was increased, highlighting the benefits of time diversification.
As we mentioned before, this increase in reliability through diversification is because not all stocks have the same performance and only a subset will contribute to a positive premium realized over a certain time period. As Dimensional eloquently puts it, “a concentrated portfolio can produce extremely good or extremely bad performance, exposing investors to much greater uncertainty around the investment outcomes.”
The other benefits associated with taking a broad approach to targeting premiums is the low turnover and the ability for cost savings through patient and flexible trading. Both of these benefits are passed onto investors in terms of realized return.
IFA advises clients to take advantage of premiums that have been shown to be highly present in markets around the world. Taking a diversified approach that is cost-effective increases our client’s chances of capturing those premiums and making the most of the risk they are taking within their portfolios.
 Dai, Wei. “How Diversification Impacts the Reliability of Outcomes.” Dimensional Fund Advisors, LP. November, 2016.
About the Authors
Tom Allen is an Accredited Investment Fiduciary (AIF®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFA®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.