What to do when diversification is not enough

Portfolio diversification has two problems:

  1. It can significantly reduce potential gains
  2. It does not provide a portfolio with enough protection

A diversified portfolio can be leveraged to realize equity-like returns but to achieve a tolerable level of risk, dynamic risk control techniques must also be employed.

Equities are a risky source of returns

Investors seek exposure to equities as a source of growth. US equities have returned an average 11.3% annualized since 1977 as represented by the S&P 500 Total Return Index. But achieving this return required investors to often endure severe drawdowns.

Drawdown: A portfolio’s percentage loss in a peak-to-trough decline before a new peak is attained. It is an indicator of downside risk over a specified time period. The maximum drawdown is the worst loss that an investor could have experienced over the period.

Over the past 42 years there have been 13 drawdowns greater than 10% – that’s one almost every three years. The two largest drawdowns: -47% following the late 90s tech bubble and -55% during the 2008/09 financial crisis have occurred within the last two decades.

Diversification reduces risk but can also reduce return

A diversified portfolio typically sacrifices returns as allocations to higher returning asset classes are diverted to less correlated asset classes that may carry lower returns. Bonds have traditionally been used as a diversifier to equities with a conventional “moderate” portfolio maintaining 60% equities and 40% bonds (“60/40”).2

Since 1977, a US equity portfolio returned 1.3% per annum greater than the 60/40 portfolio, amounting to a 64% greater total return at the end of the period. The opportunity cost can be even larger during periods of predominantly rising equity markets. For example, the US equity portfolio outperformed the 60/40 portfolio by 4.3% per annum since 2008. In addition, during the financial crisis, the 60/40 portfolio experienced a drawdown of -35% which is too large for most investors should a similar market event occur.

Other asset classes can be added to the diversified portfolio to improve results but would not materially change the conclusions for the representative portfolio.

Enhance return through the use of modest leverage

Leverage: strategy of using borrowed capital as a funding source to expand the asset base which amplifies profits and losses.

A diversified portfolio can be leveraged in order to have the same level of return as a 100% investment in equities. While the use of leverage increases portfolio risk, a leveraged diversified portfolio can have lower risk than a 100% investment in equities.

Since 1977, a 60/40 portfolio with 1.3 times leverage (or exposure of 80% equities and 53% bonds) would have achieved the same return as US equities but with lower risk.

While the leveraged 60/40 portfolio had lower drawdowns in each of the periods when equities declined greater than 10%, it is still significantly risky. During the 2008/09 financial crisis, a leveraged 60/40 portfolio would have had a drawdown of -45%. Clearly, there is need for improvement with regards to risk-management in both of the portfolios outlined. Other risk control techniques need to be employed to produce tolerable levels of risk.

Next level of risk control strategies

Diversification is not enough. As a risk control strategy it does not deliver adequate protection and can also significantly reduce potential gains. A leveraged diversified portfolio can be a good starting point. The next step is to employ dynamic risk control techniques in the investment management process. See our previous posts: Investing in Volatility to hedge equities and Utilizing treasuries as a hedge.

Disclosure: AnchorPath maintains exposure to the S&P 500 Index and Bloomberg Barclays US Aggregate Bond Index through index-based financial instruments in its portfolio strategies. AnchorPath also employs embedded leverage in its portfolio strategies.

1 The S&P 500 Index is represented by the S&P 500 Total Return Index. Risk and return statistics calculated from 1977 – 7/31/2018 using daily return data.

2 The 60/40 portfolio is represented by 60% S&P 500 Total Return Index and 40% Bloomberg Barclays US Aggregate Bond TR Index. From 1977 to 1988 the calculations use monthly returns and assume monthly rebalancing; from 1989 to 7/31/2018 the calculations use daily returns and assume daily rebalancing.

3 The 1.3x leveraged 60/40 portfolio assumes financing costs equal to 1 month Libor after December 1984; for prior dates, the US Federal funds effective rate plus 20 basis points is assumed. From 1977 to 1988 the calculations use monthly returns and assume monthly rebalancing; from 1989 to 7/31/2018 the calculations use daily returns and assume daily rebalancing.


Past performance is not a guarantee of future results. Past performance is not a guarantee of future results. This material, including graphs, charts, or other devices presented, is not intended to be relied upon as a forecast, research or investment advice, nor is it a solicitation or recommendation to buy or sell any securities, product, services, to adopt any investment strategy, or the timing of such decisions. The material is subject to further review and revision. Opinions expressed are as of September 2018, may change at any time for any reason and the author’s opinions do not necessarily reflect the views of AnchorPath Financial, LLC.

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Index returns do not reflect transaction costs, fees and expenses that would otherwise reduce performance. It is not possible to invest in an index.

Leverage risk is created when an investment exposes the portfolio to a level of risk that exceeds the amount invested. Changes in the value of such an investment magnify the risk of loss and potential for gain.

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