Building a Diversified Portfolio

Last time we looked at managing risk (as measure by the standard deviation of returns) by combining funds in our portfolio that were uncorrelated, (that is they don't track each other very well on a day to day basis.)

Let's start by taking a quick look at one of the standard examples. One common allocation model (taken from "The Intelligent Asset Allocator" book that we discussed last time) is below. The ticker in parenthesis is the fund we will use in our study, I'm using Vanguard funds as they are the "gold standard" of index funds:

25% in Large US Stocks (VFINX)
25% in small cap US stocks (NAESX)
25% in intermediate term bonds (VBIIX)
25% in international stocks (VGTSX)


For the examples we will look at, we set up a portfolio with the percentages shown, and then rebalance every quarter. We looked at the 11 year period from 1995 to 2005 inclusive.

Diversified Portfolio Performance

	Ann Rtn	MDD	Std Dev
VFINX	10.7%	47.5%	20.2%
VGTSX	4.8	50.6	19.6
NAESX	11.9	43.1	17.4
VBIIX	7.6	7.3	6.1
Port	10.1	29.9	12.5

Port = Portfolio rebalanced quarterly
Ann Rtn = Annualized return over the 11 years
MDD = Maximum Drawdown (our simple measure of risk)
Std Dev = Standard Deviation of the annual returns, another measure of risk


These results are simulated, and are not a prediction of future results

So this really works! The overall return was still over 10%, just under that of the S&P 500, but the MDD for the portfolio is only about 2/3 of the S&P alone, and the standard deviation of the returns dropped to about 2/3 as much as well. We got 94% of the returns, but less than 2/3 the risk. That's great.

Now, here's where I will part company with William Bernstein, the author of "The Intelligent Asset Allocator." His contention is the only way to generate above market returns with lower risk is through asset allocation. We think that by sector rotation we can generate returns above the market, and with lower risk as well.

So, what if we start with those funds that have higher overall returns, and lower risk as well.

Next time: We'll take a look at using some of the Fundztrader systems to turbocharge this diversification strategy.