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I wanted to ask a follow up questions to the questions linked below.

Why would I want a diversified portfolio, versus throwing my investments into an index fund?

I have a personal financial adviser who follows the diversified portfolio theory, and I've read the explanations in that answer as well as heard of the advantages of a diversified portfolio. However, has anyone put together data that a diversified portfolio of some sort has actually outperformed the S&P 500? I've seen the Blackrock Asset Class returns chart many times and I can see you end up with more stability with the diversified portfolio, but I've never seen anyone cite anything that says such a diversified portfolio actually outperforms the S&P 500 over any time period.

I realize measuring performance can be tricky, as it may depend on which years you choose, or the dates you start your year, but nonetheless, my sense is the diversified portfolio argument is cited as something that's theoretically great, but no one has put together solid data over a long period to show it's better.

EDIT: people have asked for clarification of diversity. By diversity, I mean a portfolio that has holdings from most/all of the assets classes shown in the linked Blackrock chart. I've run into a number of financial advisers who essentially advocate holding as many of those asset classes since you don't know which class will be the best performer.

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jfoo
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  • Note that the answer to the original question isn't either/or. I have a diversified portfolio of index funds. – keshlam May 15 '14 at 21:11
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    Over 2008 the S&P 500 had a performance of about -40%. A portfolio of half cash, half S&P 500 would have outperformed this. Tada, there's your data. – AakashM Jul 31 '14 at 11:28
  • Its also worth pointing out that index funds are always outperformed by their index (they charge fees that overtime cut into growth) so it is worth comparing the fees associated with buying into and index or a diversified set of stocks – sdrawkcabdear Sep 20 '16 at 21:20

4 Answers4

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Is it POSSIBLE? Of course. I don't even need to do any research to prove that. Just some mathematical reasoning:

Take the S&P 500. Find the performance of each stock in that list over whatever time period you want to use for your experiment. Now select some number of the best-performing stocks from the list -- any number less than 500. By definition, the X best must be better than or equal to the average. Assuming all the stocks on the S&P did not have EXACTLY the same performance, these 10 must be better than average. You now have a diversified portfolio that performed better than the S&P 500 index fund.

Of course as they always say in a prospectus, past performance is not a guarantee of future performance.

It's certainly possible to do. The question is, if YOU selected the stocks making up a diversified portfolio, would your selections do better than an index fund?

Jay
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    I think it's implied that by "diversified portfolio", the OP means something with greater diversification than S&P 500. – Daniel Lubarov May 16 '14 at 05:44
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    @daniel Hmm, I'd think the S&P 500 is a pretty "diverse" collection. Is there a formal definition somewhere of "diverse portfolio"? I've always understood it to simply mean a collection of stocks, bonds, maybe derivatives, whatever, in companies from a variety of industries and of a variety of capitalization sizes. I'd have to study a list of what's on the S&P 500 but I'm sure it's a variety of industries. I guess it's mostly large cap. But still, okay, if the question is, could you find SOME collection of 10 or 20 stocks, including some not on the S&P 500, that beat the S&P 500 average ... – Jay May 16 '14 at 13:21
  • ... in a specified time period? Yes, you'd have to do some research to prove that such a collection exists. But I'd be greatly surprised if you could not find SOME set of stocks that beat the S&P 500, if the 20 (say) best performing stocks in the world did not do better than the S&P 500. The S&P 500 is deliberately designed to be representative of the economy as a whole, not to be a collection of the best performers. – Jay May 16 '14 at 13:31
  • I guess the OP's question wasn't that clear, but I think this is what he was getting at: say you divide your funds (and regularly rebalance) between S&P 500, a small cap fund, a foreign stock fund, an REIT fund, and so forth. Could such a portfolio outperform all of the underlying asset classes? It is sometimes claimed (e.g. by Wealthfront) that rebalancing not only decreases risk but also increases expected gains; I think the OP was looking for evidence to support or repudiate these claims. – Daniel Lubarov May 16 '14 at 17:43
  • @Daniel It's certainly possible that I'm misunderstanding the question. But your interpretation, as worded, is easy to answer: No, that's not possible. You're saying Could I average 4 numbers together and get a result that is larger than all of the original 4 numbers? No. An average must be less than or equal to the largest number contributing to that average. I think the REAL underlying question is, "Am I better off putting together a diversified portfolio, or using an index fund, in terms of risk versus likely gains?" But phrased that way, the question is pretty much impossible to answer ... – Jay May 16 '14 at 19:00
  • ... How much risk offsets how much potential gain? Like if one portfolio had a 90% chance of making 10% and a 10% chance of losing 10%, while another had a 80% chance of doubling your money but a 20% chance of going completely bust, which would you prefer? There's no formula to answer that. But most important: who is picking the individual stocks that make up the portfolio, and on what basis? Obviously, in any given period of time some stocks with outperform the averages and others will underperform. If you average together every possible portfolio, that should give pretty much the same ... – Jay May 16 '14 at 19:07
  • ... results as a broad index fund. If the person picking the stocks is intelligent and has some foresight on how the market might go, you'd think he'd do better than the almost-random collection of stocks that make up an index fund. But in practice that doesn't seem to be reliably true: lots of mutual funds underperform the averages. (This 3-part comment should have been an addendum to my answer. Apologies to the admins.) – Jay May 16 '14 at 19:09
  • quite a discussion in comments... :) To clarify, I meant a diversifed portolio across asset classes, including stocks of different sectors as well as bonds, cash, and possibly real estate? There's a lot of advisers who advocate building a portfolio with many of the classes shown in the BlackRock chart that I linked, and I'm just wondering if your approach is to invest in all those classes, if you can all it better than the S&P 500 since it smooths out gains and losses. – jfoo May 16 '14 at 19:35
  • @Daniel, you are spot on with that I was looking for. I'm looking if there's empirical evidence that a balance portfolio actually works, vs. S&P 500. – jfoo May 16 '14 at 19:38
  • Also, looks like the Wealthfront link cites a couple of books that show a rebalanced, portfolio performs the same with lower risk (I haven't read these yet).

    Unconvention Success

    The Elements of Investing

     – jfoo May 16 '14 at 19:41
  • @Jay just to clarify, those who claim that diversification can improve expected gains mean diversification with periodic rebalancing. When you rebalance, you sell some of each asset which increased in price and buy more of each asset which decreased in price, so rebalancing is a contrarian strategy of sorts. One could argue that price movements tend to be unjustified or exaggerated, so by rebalancing you're exploiting inefficiencies in pricing and increasing the true long term value of your portfolio. I don't know how well the data supports that though. – Daniel Lubarov May 16 '14 at 19:50
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    @Daniel - or rebalancing can be seen as selling your winners and buying more of your losers. – Victor May 16 '14 at 21:24
  • @victor Yes. And you could circle around that forever. If you sell the stocks (or bonds or whatever) that went up, are you selling them while they're at a peak? Or are you missing out on future gains? If you buy a stock that's going down, do you have any reason to think that it will go back up? Or are you investing in a known loser? Of course if I knew the answers, I'd be a lot richer than I am now. I've bought several stocks on the thought, "That company has had some hard times, there's nowhere to go but up." And I've been wrong every time: they kept going down. – Jay May 19 '14 at 13:16
  • @Daniel Well, the argument I've always heard for a diversified portfolio is that it reduces risk by protecting you from unanticipated swings in one company or one sector. If I put all my money in one company, and then that company gets a new CEO who turns out to be incompetent, or they get hit with some big law suit, etc etc, than one event totally beyond my control destroys my portfolio. But if I invest in 100 companies in different industries, they're not ALL going to make a stupid mistake at the same time, and they're not likely to ALL get hurt by some outside ... – Jay May 19 '14 at 13:21
  • ... event. The flip side to that is that it "protects" you against gains, too, because if you invest in 100 companies, they're not all going to do something brilliant at the same time either. – Jay May 19 '14 at 13:22
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Stocks, Bonds, Bills, and Lottery Tickets notes the work of Fama and French who researched the idea of a small-cap premium along with a value premium that may be useful to note in terms of what has outperformed if one looks from 1926 to present.

Slice and dice would also be another article about an approach that over weights the small-cap and value sides of things if you want another resource here.

JB King
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While it's definitely possible (and likely?) that a diversified portfolio generates higher returns than the S&P 500, that's not the main reason why you diversify. Diversification reduces risk.

Modern portfolio theory suggests that you should maximize return while reducing risk, instead of blindly chasing the highest returns. Think about it this way--say the average return is 11% for large cap US stocks (the S&P 500), and it's 10% for a diversified portfolio (say, 6-8 asset classes). The large cap only portfolio has a 10% chance of losing 30% in a given year, while the diversified portfolio has a 1% chance of losing 30% in a year. For the vast majority of investors, it's worth the 1% annual gap in expected return to greatly reduce their risk exposure.

Of course, I just made those numbers up. Read what finance professors have written for the "data and proof". But modern portfolio theory is believed by a lot of investors and other finance experts. There are a ton of studies (and therefore data) on MPT--including many that contradict it.

Stephen C
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Yes, a diversified portfolio can generate greater returns than the S&P 500 by going OUTSIDE it.

For instance, small stocks (on average) generate higher returns than the "large caps" found in the S&P 500. So if you own a diversified portfolio of stocks, some of which are smaller (in market cap) than the typical S&P 500 stock, you have a chance to outperform.

You might also outperform by owning other asset classes than stocks such as gold, real estate, and timber (among others) at appropriate times. (You may also be able to get the relevant exposure by owning gold and timber stocks and REITS.) This was a lesson that David Swensen of the Yale endowment taught us.

Tom Au
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