October 2, 2006

The Case for True Diversification--Searching for Alpha, October 2006

The monthly index newsletter for October 2006

It's been a long six years for investors in the Dow Jones Industrial Average. After a spectacular third quarter this year, the oldest index of U.S. stocks is now a breath away from the all-time high of 11,722.98 set on January 14, 2000.

The flat performance of such a well-known index is a bit disappointing, considering the hype about diversification we've all been forced to hear. In fact, considering the conventional wisdom that one can replicate the returns of the U.S. market with 10 to 30 stocks, one might think that a well-designed index of 30 leading domestic names would do better than post a break-even showing after six years.

As it turns out, all the studies (see Statman, M. "How many stocks make a diversified portfolio?" in the September 1987 Journal of Financial and Quantitative Analysis) that show the relative ease of capturing the return of the entire market with a few handfuls of equities have one thing in common--their use of the standard deviation of returns as the sole descriptor of risk. Unless one is capable of holding a much larger portfolio, one that could minimize the myriad economic risks to stocks that simply can't be captured by its volatility of returns, investors have a good change of seeing the performance of their mini-index slowly drift away from the broader market.

A more rational gauge for advisors is terminal wealth dispersion (TWD). This handy metric measures the variability of an account with a defined holding period. For parents who have ten years to save for college education costs, a TWD-mandated portfolio would seek to maximize the odds the account would get to a given value. A study by Edward O'Neal reported in the March 1997 issue of the Financial Analysts Journal, "How Many Mutual Funds Constitute a Diversified Mutual Fund Portfolio?" showed that the dispersion of one's terminal wealth can be dramatically reduced by as few as six mutual funds, even if some of the funds have the same investment objectives.

I view TWD as the application of mathematics to common sense. In the last six years of flat equity performance, the Lehman Aggregate Bond index, the Dow Jones REIT index, and the HFR Fund of Hedge Funds index gained 52%, 135%, and 43%, respectively. Putting all of one's eggs in the same basket never looked so unattractive.

The Monthly Index Report for October 2006

Index

Sep-06

QTD

YTD

Description
S&P 500 Index*

2.46%

5.18%

7.01%

Large-cap stocks
DJIA*

2.62%

4.75%

8.97%

Large-cap stocks
Nasdaq Comp.*

3.42%

3.98%

2.41%

Large-cap tech stocks
Russell 1000 Growth

2.75%

3.88%

2.97%

Large-cap growth stocks
Russell 1000 Value

1.99%

6.25%

13.19%

Large-cap value stocks
Russell 2000 Growth

0.68%

-1.70%

4.21%

Small-cap growth stocks
Russell 2000 Value

0.98%

2.50%

13.25%

Small-cap value stocks
EAFE

0.17%

3.99%

14.91%

Europe, Australasia & Far East Index
Lehman Aggregate

0.88%

3.81%

3.06%

U.S. Government Bonds
Lehman High Yield

1.42%

4.08%

7.34%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

-0.06%

-2.32%

-0.67%

Managed Futures
3-month Treasury Bill

3.56%

All returns are estimates as of September 30, 2006. *Return numbers do not include dividends. ** Returns are estimates as of September 28, 2006.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at ben@searchingforalpha.com.

Reprints Discuss this story
This is where the comments go.