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Diversifying wealth with the intent of reducing risks has been a common practice throughout history. Even the fictional Don Quixote of La Mancha, who tilted at windmills in the early seventeenth century, had the wisdom not to "venture all his eggs in one basket."
Today, applying this age-old concept involves combining assets that behave differently in similar environments, which may produce advantageous results.
The benefits of creating diversified portfolios using multiple asset classes with dissimilar patterns of returns (referred to as low correlations) have been well documented since the 1950s, when economist Harry Markowitz, a pioneer of modern portfolio theory, statistically demonstrated the risk-return benefits of a diversified portfolio. In 1990, Markowitz won the Nobel Prize in Economics, in part for his work on portfolio optimization.
In a 1998 study, Roger Gibson, a pioneer in the theory of strategic asset allocation, demonstrated how combining asset classes within a single portfolio can boost returns while at the same time reduce volatility. Specifically, Gibson showed that combining asset classes with disparate patterns of returns (low or negative correlations) could generate greater returns with significantly less overall volatility than a weighted average of the component asset classes.
In other words, by combining less-attractive asset classes (lowest returns and highest risk) with better-performing asset classes, the combined portfolio produced higher returns and with less volatility than either asset class individually because of different return patterns (assuming the portfolio was rebalanced regularly). The theory worked when just two different asset classes were combined, but results were more pronounced when three and four different asset classes were combined within a portfolio.
For his study, Gibson assigned equal allocations to each of the four asset classes—U.S. stocks, international developed-country stocks, real estate investment trusts (REITs), and commodities—and measured performance over the period from January 1, 1972–December 31, 1997.
In a 2005 update of his research, Gibson observed 15 equity portfolios over the period of 1972–2005. Four of the portfolios were comprised of a single asset class; six were comprised of two asset classes equally allocated; four were comprised of three equally allocated asset classes; and one was comprised of four equally allocated asset classes (U.S stocks, non-U.S. stocks, real estate securities, and commodities). (Note that regular [quarterly] rebalancing is essential to the success of the strategy.)
By virtually every measure, the advantages of combining multiple-asset-classes with different patterns of return were obvious: multiple-asset-class portfolios in general had higher returns and lower volatility than single-asset-class portfolios over time. This held true even in the case of the best-performing single-asset-class. Real estate securities had both a higher return and less volatility than any of the other asset classes. Yet a portfolio allocated equally among all four asset classes produced nearly the same returns, but with a third less volatility.
Improving on Gibson
Implicit in Gibson's theory was the pure interplay between asset classes with diverse return patterns. The multiple-asset portfolios he studied were equally allocated among the component asset classes. Beyond rebalancing regularly to maintain that precise allocation, Gibson did not actively manage the portfolio holdings and simply let the correlations—or lack thereof—produce the results. And the results, in general, were superior to single-asset-class investments over the long term.
So imagine the potential results that might be derived from an actively managed portfolio that not only combines select asset classes with different return patterns but also has the added benefit of the ongoing tactical management of professional investors.
Because different asset classes perform better or worse in different environments, a skillful investment strategist can add to the benefits of diversification by overweighting undervalued asset classes with the intention of increasing returns and underweighting areas of potential risk.
For example, according to Lord Abbett research, in eight of the past 10 years, the difference in returns between U.S. stocks (as represented by the S&P 500® Index1) and U.S. bonds (as represented by the Barclays U.S. Aggregate Bond Index2) has been 5% or more. In a single portfolio that contains both asset classes, an active manager can potentially add to performance by deliberately favoring the more attractive asset class. Similarly, in nine of the past 10 years, the difference in returns of U.S. and non-U.S. stocks (as represented by the MSCIEAFE Index3) has been at least 5%. That presents opportunity to tilt the geographical allocation of the portfolio seeking to realize gains. The pattern applies to fixed income as well, where during seven of the last 10 years there has been at least a 5% difference in the returns of investment-grade bonds and high-yield bonds (as represented by the BofA ML High Yield Master II Constrained Index4).
The extent of the tilting and the timing are critical to the success of the strategy. Tilting too far for too long will diminish returns, while failing to fully realize the value of an asset class suggests missed opportunity.
The skillful multi-asset manager strives to optimize the timeless benefits of diversification, along with the timely advantages of tactical investing.
Of course, there is no guarantee that these asset classes will perform in a similar manner under similar. conditions in the future. It also is important to remember that asset allocation does not guarantee a profit or protection against loss.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Risks to Consider:
The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. These risks may be greater in the case of emerging country securities. No investing strategy can overcome all market volatility or guarantee future results.
Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.