A history lesson in the benefits of diversification
Diversification is a useful tool in enabling investors to grow their wealth in excess of inflation over time. By diversification we mean including asset classes in a portfolio that react differently to prevailing market conditions. By diversifying in such a manner we can expect higher probabilities of beating inflation than would otherwise be achievable.
By reviewing the returns of the major asset classes (local equity, international equity, local bonds and local cash) since 1960, history shows us that diversification has indeed benefited investors. Firstly, let us consider the performance of these asset classes individually. The table below shows the annualised return above inflation and the risk (risk or volatility is a widely accepted statistical measure of the degree of variation of return), of each of the asset classes over the 47-year period starting in 1960. In this example we have not taken costs or tax into consideration.
Returns of the major asset classes (in excess of inflation)
Local Equity
Internat. Equity
Local Bonds
Local Cash
Return
8.90%
7.20%
1.80%
2.00%
Risk
21.50%
17.30%
7.70%
1.40%
Source: Nedgroup Investments, 1960-2006
One can immediately see that local equity, while providing the greatest annualised return (8.9% pa above inflation) over the period, also appears to be the riskiest. International equity has produced returns of 7.2% pa above inflation (in rand), with slightly less risk than local equities. Local bonds have produced the lowest return over the period (1.8% pa), while local cash has been the least risky asset class. Inflation has been 8.5% pa, on average, over the period.
We are also able to calculate how often the individual asset classes outperformed inflation over various time periods. The table below gives the percentage of periods that each of the asset classes has outperformed inflation. The final column in the table shows the success rate for a typical diversified portfolio consisting of 60% local equity, 15% international equity, 15% local bonds, and 10% local cash that has been re-balanced monthly.
| Probability of asset class / asset mix outperforming inflation over period (pre-tax) | |||||
| Local Equity | Internat. Equity | Local Bonds | Local Cash | Diversified Portfolio | |
| 1-year | 67% | 65% | 58% | 73% | 72% |
| 3 years | 79% | 75% | 60% | 71% | 85% |
| 5 years | 87% | 69% | 50% | 71% | 89% |
| 10 years | 95% | 77% | 44% | 68% | 95% |
| 20 years | 100% | 100% | 41% | 54% | 100% |
Source: Nedgroup Investments, 1960-2006
From this one can see that over any 1-year holding period, local equity has a 67% chance of outperforming inflation, while over any 10-year holding period this increases to 95%.
Some very clear trends emerge from the data:
* The higher risk asset classes (local and international equity) offer a greater chance of producing inflation-beating returns than lower risk asset classes (bonds and cash), except over 1-year periods. In terms of what investors' true objectives are, it therefore appears that the existing definition of risk is misleading, as the asset classes that are conventionally understood to be the 'riskiest' actually have the highest probability of outperforming inflation over all but the shortest periods.
* As the investors time horizon increases, higher risk asset classes have a significantly improved chance of beating inflation, while lower risk classes have worsened chances.
* For all periods greater than one year the chance that the diversified portfolio outperforms inflation is at least equal to, or better, than the chance that any individual asset class will beat inflation. This means that one can use assets that individually have lower probabilities of beating inflation to construct a portfolio that has superior inflation-beating characteristics. This is diversification at work.
* Costs obviously have the ability to erode the likelihood of success. We calculate that costs of 1.5% per annum would reduce the chance of success by 3-4% for the diversified portfolio.
* Income and capital gains taxes also have the ability to erode the chance of success. Cash and bonds are taxed far more punitively than equities. The table below highlights this fact dramatically:
Change in probability of asset class / asset mix outperforming inflation over period - after tax (30%)
Local Equity
Internat. Equity
Local Bonds
Local Cash
Diversified Portfolio
1-year
0%
0%
-12%
-31%
-2%
3 years
-1%
-1%
-19%
-33%
-2%
5 years
0%
-1%
-16%
-30%
-3%
10 years
0%
0%
-16%
-34%
-2%
20 years
-1%
0%
-18%
-36%
-3%
Source: Nedgroup Investments, 1960-2006
Investors have different objectives, but achieving inflation-beating returns is still the top priority for most. Although we can't necessarily expect history to repeat itself, we can certainly take note of the lessons that it teaches us. In this instance, it is clear that diversification has been a highly effective tool to increase the likelihood of consistently outperforming inflation. The effect of costs and taxes on the likelihood of success also need to be clearly understood.
By Matthew de Wet and Anil Jugmohan, Nedgroup Investments
