Benefits Of Diversification
The diversification benefits can be seen in Table 3. This table shows the mean premium for each of the factors, the volatility of the factor and its Sharpe ratio. It also provides the same information for three portfolios.
Portfolio 1 (P1) is allocated 25% to each of four factors (beta, size, value and momentum). Portfolio 2 (P2) is allocated 20% to each of the same four factors and adds an allocation to the profitability factor. Portfolio 3 (P3) is allocated the same way, substituting the quality factor for the profitability factor.
The low correlations among the factors resulted in each of the three portfolios producing higher Sharpe ratios than any of the individual factors. Furthermore, we can see the benefits of diversifying across factors in the table below, which shows the odds of underperformance over various time horizons.
As you can observe, no matter the horizon, the odds of underperformance are lower for each of the three portfolios than for any of the individual factors.
Playing The Odds
There is one other important takeaway that relates to an issue I am often asked to address. Some investors will see this data and say: “But I don’t have 20 years to wait for a premium to be realized.” The best way to think about this, however, is relatively simple.
Unfortunately, there are no clear crystal balls in investing. Thus, the best we can do is to put the odds of success in our favor as much as possible. As the above tables show, regardless of your investment horizon, be it one year or 20, you are always putting the odds in your favor by gaining exposure to any of these factors. It’s just that the odds grow increasingly in your favor the longer the horizon.
Because any factor can deliver a negative premium over even long horizons, the prudent strategy is obvious: Diversify across factors and don’t put too many of your investment eggs in any one of them. But, as Buffett said, while investing really can be that simple, it’s not easy to ignore what feels like long periods of underperformance. And that leads to impatience and the loss of discipline.
The bottom line is that an investor’s worst enemy is staring right back at him when he looks in the mirror. One of my favorite expressions is that knowledge is the armor that can protect you from making bad decisions. You have the knowledge. Now all you need is the discipline.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.