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Stock Returns May Not Be What They Seem

Buyer beware when investment marketers give performance comparisons.

John Rekenthaler, 12/29/2016

Two Beats One
For the 19-year time period of 1997-2015, gold almost exactly kept pace with the Dow Jones. Ten thousand dollars invested in the Standard & Poor’s Spot Gold Index in January 1997 had become $28,716 by year-end 2015. The comparable figure for the Dow Jones Industrial Average was $28,905. Of course, while the two indexes ended near the same place, their paths were quite different; ‘twas merely by accident that they finished together. This is what their paths looked like.
  - source: Dow Jones, S&P, Morningstar

Per the basics of investment math, if two assets have the same rate of return and are imperfectly correlated (or better yet, perfectly negatively correlated), then it makes sense to hold both in a portfolio, rather than one or the other.

The common cited reason is risk reduction; the vendor who sells both sunscreen and umbrellas won’t ever go home having sold her entire inventory, as might those who hawk only sunny- or rainy-day products, but unlike the specialists she will always go home with something. Holding two assets rather than one improves peace of mind--over time, the profits for the specialists might be similar, but they will have endured more rotten days along the way.

But that perspective can be flipped. Just the tactic of combining assets can be thought of as reducing risk for a given level of return, it also can be regarded as increasing returns for a given level of risk. In other words, diversification does more than soothe frayed nerves. It puts extra money on the table.

For Example
A simple example: Oddball Corporation’s stock gains 15% in odd-numbered years and loses 5% in even-numbered years, while Evenhanded’s stock does the opposite. A $10,000 investment in Oddball thus grows to $11,500 in 2017, then shrinks to $10,925 by December 2018. For its part, Evenhanded initially drops to $9,500, then improves to $10,925. (The commutative property works!) The savvy investor, however, puts 50% of her money into each stock, and rebalances annually. Her two-stock portfolio gains 5% each and every year, so that she has $10,500 at the end of 2017, and $11,025 one year later.

Less risk, more profits. Sign me up, please.

The Dow Jones and gold indexes don’t operate as neatly as do Oddball and Evenhanded, or the finance professors’ vendor metaphor (to which, yes, I was subjected in business school). When Dow Jones zigs, gold does not consistently zag. Nonetheless, over that time period--and such analyses are always time-period dependent, as there are no guarantees about future returns and correlations--there was a clear benefit from combining the two. The next chart updates the first graphic, adding a portfolio that consists 80% of Dow Jones, 20% of spot gold. The end point is a bit difficult to make out, but rest assured, it is higher than each of the individual assets, finishing at $31,246. The sum is indeed greater than the parts.


 - source: Dow Jones, S&P, Morningstar

is vice president of research for Morningstar.

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