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Fun with Diversification

We learn at an early age not to put all our eggs into one basket (although few of us walk around with a basket of eggs). An obvious application of this saying involves investing. We know that sometimes a particular asset class is in favor, while at other times it can get a bit ugly. So it makes sense to expose yourself to a diversified group of asset classes to insure a smoother ride.

The topic of diversification can lead us to many interesting and complex areas, but let's focus on a simple comparison of large cap U.S. stocks (S&P 500) and several foreign stock indices -- broad-based (MSCI EAFE), general emerging markets (MSCI Em Mkts) and the flavor-of-the-month, Brazil, Russia, India, and China (MSCI BRIC).


We can see in the chart below that foreign stocks have mostly outperformed the S&P 500 if you have been patient. In the first eight months of this year (YTD), however, foreign equities have been a significant drag on your stock returns.

Performance

 

YTD

3 Yrs

5 Yrs

10 Yrs

15 Yrs

S&P 500

-1.77

0.54

0.78

2.70

6.13

MSCI EAFE

-6.02

-2.96

-1.48

4.96

4.15

MSCI Em MKts

-11.26

1.04

8.56

19.38

11.33

MSCI BRIC

-8.31

5.36

8.72

16.29

7.96

 

In other words, looking at your August 2011 brokerage statement may cause you to wonder why you're investing in foreign stocks. A longer time perspective provides the answer.

The long-term out-performance of emerging markets and BRICs came with a cost -- increased volatility as measured by standard deviation (see chart below). Think of volatility as a roller-coaster. The larger the standard deviation, the greater the ups and downs. Some people may be willing to give up the potential for higher returns in order to avoid the turbulence.

Standard Deviation

 

3 Yrs

5 Yrs

10 Yrs

15 Yrs

S&P 500

22.36

18.78

16.36

16.98

MSCI EAFE

27.62

22.96

19.34

18.31

MSCI Em Mkts

33.47

29.62

25.59

27.11

MSCI BRIC

35.86

33.45

29.38

32.87

 

These historical returns are not destined to repeat themselves. These charts are valuable because they show us that results can vary over different time periods. Since you cannot predict with certainty which investment will be the most successful at any given time, keeping your investments in a variety of baskets still makes sense.

 

Words of Wisdom

Click: Great reasons to keep all your eggs in one basket