Rule #4 Diversification is a Free Lunch

We all pretty much know that the investments with the highest potential returns also carry the highest risk.

What if you could combine various high-return investment sectors with low correlations in a portfolio?  In principle, the risks would cancel each other out, and you could keep the returns.

This is getting harder to do, since the correlations between stocks have been increasing over the past few years.  In other words, on a good day – everything goes up.  On a bad day – everything goes down.

Sam Stovall recommends sector diversification in a very simple sense.  In his book, he identifies two sectors that have had strong historical performance and low correlations.  These are health care and technology.  One does better in bear markets, the other is a bull-market favorite.

In the 1990-2007 timeframe, they have returned 9.1% and 10.8% respectively, with a correlation coefficient of 0.28 (1 is high correlation, 0 indicates no relation whatsoever).  Over the same period, the compound growth rate of the S&P 500 was 8.2% (yes, those were the days!)

A 50/50 split between  a consumer staples ETF (ticker: XLP) and an information technology ETF (ticker:  XLK), rebalanced annually, would have generated 11.2% annual returns, with just two-thirds of the annual volatility of the S&P 500.  That is an extra 3% per year return, with less risk.   The result is better than investing individual in either sector on a standalone basis.

This is the type of experiment that looks great in a backtest, but you should wonder if this strategy would be as robust going forward.  Remember, most of the data was drawn from the 1990’s, when people were ga-ga for technology.  Also,  the best performing sector for the past 50 years was consumer staples, which may have been fueled by the baby boom.

So, it looks like we are playing with a stacked deck here.  This experiment significantly benefits from hindsight.  Correlation coefficients between sectors have also been climbing over the past few years, reducing the effects of diversification.

It might make sense to use a similar strategy, though, using asset classes and sectors that offer the best prospective returns on a forward-looking basis.   My guess is that healthcare is worthy of consideration, along with technology.

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