Diversification Raises Returns, Lowers Risk -- Here's Proof

My last three columns (from Dec. 21 , Jan. 17 and Feb. 1 ) have focused on analyzing stock market sectors. Many readers -- particularly those who were burned last year by an overexposure to technology -- wrote to say they had never considered sector exposures in assessing portfolios risk.

So I thought a good way to end this series would be a demonstration of how, over time and through bull and bear markets, a sector-diversified portfolio earns higher returns with lower risk (the Holy Grail of portfolio management) than a nondiversified portfolio.

I put together a demonstration focusing on technology, health care and financial services -- sectors I believe will continue to grow faster than the S&P 500 index. You could, for example, put all your money into a technology fund, knowing that over time this fund will substantially outperform the S&P 500. But as James Cramer noted a few weeks back, you can get really punished in an off year. What happens to a portfolio where you initially allocate one-third of your assets to each of these three sectors and rebalance back to those one-third allocations every January?

Choosing the Right Data

Whenever you undertake a quantitative study, you need to make sure your data cover multiple scenarios, such as economic expansions and recessions, bull and bear stock markets. I decided to use three mutual funds, FIDSXFidelity Select Financial Services, FSPHXFidelity Select Healthcare and FSPTXFidelity Select Technology to represent the three sectors. These funds have been around since the early 1980s, and I can get price data for them going back 14 years through several stock market corrections, a couple of bear markets and two full economic cycles.

Analysis

I simulated the values of a $1,000 portfolio that was split three ways among the three mutual funds in January 1987 and rebalanced every January. Through January 2001, that portfolio would have grown to $10,965 in a tax-deferred account.

Now let's look at a breakdown of the results. For more details, download this Excel spreadsheet, which will show you rolling one-year returns for each month going back to January 1988. (Netscape users should save the file to the hard drive and open it using Excel software.)

	S&P 500	Fidelity Select Financial Services	Fidelity Select Healthcare	Fidelity Select Technology	Three-Fund Blend
Average 12-month Return	13.8%	17.3%	20.1%	27.6%	21.8%
Best 12 months	49.1	88.7	83.8	158	78.1
Worst 12 months	-20.7	-42.3	-27.8	-40.8	-30.2
Standard Deviation	13.0	23.3	21.1	34.8	19.0
Probability of 1-Year Loss	14.5	22.9	17.0	21.4	12.5
Probability of 1-Year Gain	85.5	77.1	83.0	78.6	87.5

What can we learn from this summary? The S&P 500's best return for a 12-month period was 49.1%, its worst was a loss of 20.7%, and the average was 13.8%. The standard deviation -- a measure of how the annual results were dispersed -- was 13%. Standard deviation, which can be calculated by the Excel spreadsheet, is a very useful measure. In a normally distributed series, 68% of all results will be within plus or minus one standard deviation, which is say that under normal conditions, 68% of the time the S&P 500 will return between 0.8% and 26.8% (subtract or add the standard deviation from the average). A higher standard deviation implies higher risk, and it's not surprising that Fidelity Select Technology has the highest standard deviation among our three choices.

Another Excel function estimates the chance of falling below or above a certain value. If you want to know the chance of losing money for any one-year period, enter a target value of zero. You'll find there's a 14.5% chance of losing money over one year investing in the S&P 500. For the sector funds, the chance of losing money in any one-year period is even higher.

Consider the best- and worst-case results for each sector, particularly if you can remember what was going on when that result occurred. For example, the technology fund gained 158% in the one-year period ending February 2000. That was just before the end of the great Internet boom when companies like Yahoo! YHOO rose 10-fold. The year the financial services fund lost 42.3% coincided with the 1990 banking crisis during which Citigroup C fell to a single-digit stock price.

The blended portfolio has the second-highest return after the technology fund, but its volatility (standard deviation) is lower than those of any of the sector funds. As I discussed in How to Choose the Right Sectors for this Economy, these three sectors move differently according to the state of the economy. In the blended portfolio, the sector zigzags offset each other, leaving smoothed but higher returns relative to the S&P 500. Also, although this portfolio is more volatile than the S&P 500 (which contains other less-volatile components), the chance of having a negative year is actually lower with the blended portfolio because of the additional 8% average return.

The next time you review your portfolio allocations, add up the percentages of your stock positions invested by sector to see whether you're exposed to sector risks. If you invest primarily through mutual funds, check the sector allocation data readily available from TheStreet.com mutual fund pages. Consider rebalancing if one or more sectors are over represented.

More Resources

Since writing my sector tools column article a few weeks back, I have come across two additional resources.

ClearStation publishes a relative strength index and fundamentals index, both broken down by sector. Smartmoney.com publishes a Map of the Market that you can use to visually identify hot sectors and hot companies within those sectors during various time periods in the last year.