Wednesday, April 23, 2008

Calculate Your Diversification Benefit

So how does diversification really impact the long-term return of your portfolio? I had the same question, so I set out to create a realistic model (which you can play with below).

To create this tool, I selected 5 asset classes: the S&P500 Index; the Russell 2000 Index; the Dow Jones Industrial Index; real estate assets as represented by Vanguard's Total REIT Index Fund (VGSIX); and global stocks as represented by Vanguard's Total International Index (VGTSX). To create this tool I selected the period starting on March 1, 1997 and ending on March 1, 2008 (for no particular reason). I downloaded from Google Finance the value for each asset class on the 1st calendar day of each month within the period.

To use the calculator, enter your starting portfolio value, allocate funds to each of the five asset classes using the sliders - note that the asset classes can amount to more or less than 100% of the portfolio. The tool will graphically display your portfolio's total period risk vs. return compared to each of the asset classes.

The benefits of diversification should be pretty clear. For example, a portfolio comprised of 50% in the S&P and 50% in the REIT index has an expected return which is higher than that of a portfolio of 100% stocks, while exhibiting a lower risk profile than either asset class on its own (as measured by the standard deviation).

Finally, two caveats: there are clearly two major asset classes missing from this calculator - cash and bonds. The reason for this is that the methodology I used made it too cumbersome to factor interest into my calculations. Please also note that dividend payments are missing from the tool for all asset classes.

Enjoy, and as always, let me know if there are any other calculators that you would like to see.

Check out some of my other calculators:
Latte Factor Calculator
Cross Over Point Calculator
Value of Savings Over Time
Retirement Savings Goal Calculator

1 comment:

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