Ultimately, we conclude that “enhanced diversification” is a potential means of addressing the issues of meaningful diversification, beneficial dilution of stock risk, and improved risk-adjusted expected returns at levels that meet investor goals. We aggregate the summary statistics for the portfolios discussed throughout the Insights. The progression of decreasing concentration of stock risk and increasing Sharpe Ratios is noteworthy. We believe this makes a compelling case for “enhanced” diversification.
The Risk Contribution of Stocks – Part 1
Generally, investments with higher risk are expected to yield higher returns as an incentive to investors. Here, we do not address the issue of return. We simply focus on the risk of various stock-bond portfolios, and examine how much of this risk comes from their components, and, in particular, from stocks.
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The Risk Contribution of Stocks – Part 2
In part two we address the topic of extended diversification: How does investing in other non-correlated asset classes affect total portfolio risk and its components. This may be a particularly important issue at a time when global stock markets are near all-time highs while volatility appears to be almost unusually low.
The Risk Contribution of Stocks – Part 3
As we’ve learned in parts one and two, 92% of the risk of a 60/40 stock/bond portfolio is contributed by stocks. Diversifying the portfolio by adding managed futures yields some interesting results. As we distribute the risk of the portfolio approximately equally across the three asset classes, it turns out that the risk-adjusted expected return of the portfolio potentially improves. Among the specific hypothetical scenarios we presented, a portfolio with 20/50/30 allocations to stocks/bonds/managed futures turned out to have the highest Sharpe Ratio among portfolios whose allocations to the three asset classes were constrained to add up to 100%.
In this final Insight, we explore the possibility and the consequences of relaxing this constraint.