Diversification return

What Is Diversification Return?

Diversification return refers to the incremental return generated by a portfolio of uncorrelated or less-than-perfectly-correlated assets, stemming from the periodic rebalancing of the portfolio back to its original target asset allocation. This concept is a core element within portfolio theory, highlighting how maintaining a diversified portfolio can potentially enhance overall returns beyond what might be achieved by holding individual assets without rebalancing. The diversification return arises because rebalancing effectively forces an investor to "sell high" and "buy low" as assets deviate from their target weights due to market movements.

History and Origin

The foundational ideas behind diversification return are deeply rooted in the development of Modern Portfolio Theory (MPT), pioneered by Harry Markowitz. Markowitz's seminal 1952 paper, "Portfolio Selection," published in The Journal of Finance, revolutionized investment management by introducing a quantitative framework for analyzing the relationship between risk and return in a portfolio context.¹¹,¹⁰ Before MPT, investors often focused solely on selecting individual securities with the highest expected returns. Markowitz demonstrated that a portfolio's overall investment risk is not simply the sum of the risks of its individual components, but also depends on how those components move together, i.e., their asset correlation.⁹,⁸

His work showed that by combining assets that are not perfectly correlated, investors could achieve a more favorable risk-adjusted returns profile, meaning a higher expected return for a given level of risk, or a lower risk for a given expected return.⁷, While Markowitz's initial work laid the groundwork for understanding the benefits of combining assets, the specific concept of "diversification return" as an additional source of return from rebalancing gained more explicit recognition and study as practitioners applied MPT principles. This ongoing discipline of rebalancing is what captures the diversification return, allowing the portfolio to benefit from the cyclical nature of asset performance.

Key Takeaways

• Diversification return is the incremental gain achieved by periodically rebalancing a diversified portfolio.
• It arises from selling assets that have performed well (and thus grown in weight) and buying assets that have underperformed (and thus shrunk in weight).
• This return mechanism is distinct from the individual asset returns or the market return.
• Diversification return highlights the long-term benefit of maintaining a disciplined asset allocation strategy, rather than engaging in market timing.
• The effectiveness of diversification return is more pronounced when the underlying assets have low or negative correlations and exhibit volatility around a long-term mean.

Interpreting the Diversification Return

Understanding diversification return involves recognizing that it is not a direct investment in a security but rather an outcome of a disciplined portfolio management strategy. It's the "return from rebalancing" that occurs when assets diverge in performance and are brought back to their target weights. A positive diversification return indicates that the rebalancing process has successfully capitalized on the relative movements of different asset classes within the portfolio.

For example, if one asset class significantly outperforms others, rebalancing means reducing exposure to that asset and increasing exposure to underperforming ones. When the underperforming assets subsequently recover, the portfolio benefits from having bought them at a lower relative price. This contrasts with a "buy and hold" strategy where relative outperformance would lead to an ever-increasing concentration in the winning asset, potentially increasing portfolio volatility and systematic risk over time. Investors interpret diversification return as a quantitative benefit of maintaining a consistent risk tolerance and investment approach.

Hypothetical Example

Consider a hypothetical portfolio with an initial target allocation of 50% in Asset A and 50% in Asset B. Both assets start with a value of $10,000, for a total portfolio value of $20,000.

Year 1:

• Asset A increases by 20%, becoming $12,000.
• Asset B decreases by 10%, becoming $9,000.
• Total portfolio value is now $21,000.
• The portfolio weights are now approximately 57.14% in Asset A ($12,000 / $21,000) and 42.86% in Asset B ($9,000 / $21,000).

Rebalancing:
To rebalance back to the 50/50 target, the investor sells $1,500 of Asset A (to bring it down to $10,500) and uses that $1,500 to buy more of Asset B (bringing it up to $10,500).

• New Asset A value: $10,500
• New Asset B value: $10,500
• Total portfolio value after rebalancing: $21,000

Year 2:

• Now, assume Asset A decreases by 10% from its rebalanced value, becoming $9,450 ($10,500 * 0.90).
• Asset B increases by 20% from its rebalanced value, becoming $12,600 ($10,500 * 1.20).
• Total portfolio value is now $22,050.

Without rebalancing in Year 1, the portfolio would have started Year 2 with $12,000 in Asset A and $9,000 in Asset B. If the same percentage changes occurred:

• Asset A: $12,000 * 0.90 = $10,800
• Asset B: $9,000 * 1.20 = $10,800
• Total portfolio value without rebalancing: $21,600

The difference of $450 ($22,050 - $21,600) represents the diversification return over these two years. This gain is not from individual asset performance alone but from the strategic rebalancing that bought more of the "cheaper" asset (Asset B in Year 1) and sold some of the "more expensive" asset (Asset A in Year 1), capitalizing on their relative movements.

Practical Applications

Diversification return is a critical consideration in various aspects of financial planning and investment management. It underpins the strategic benefits of maintaining a diversified portfolio, especially for long-term investors.

1. Portfolio Construction: Understanding diversification return reinforces the principle that investors should build portfolios with assets that have low or imperfect correlation. This means combining different asset classes like stocks, bonds, and real estate, which tend to react differently to economic conditions. This approach helps reduce unsystematic risk inherent in individual securities.
2. Rebalancing Strategy: The concept directly informs rebalancing strategies. By systematically bringing a portfolio back to its target asset allocation, investors capture the diversification return. This counter-cyclical buying and selling prevent excessive concentration in assets that have performed well and allow for buying into those that have underperformed, enhancing overall portfolio efficiency. Morningstar research, for instance, consistently highlights the benefits of a broadly diversified portfolio, noting that such an approach has helped shield investors during periods of market volatility.⁶,⁵
3. Risk Management: Diversification return contributes to a more stable return path, which is a key objective of risk management. By spreading investments across different asset types, the potential for extreme losses from any single asset's poor performance is mitigated, leading to smoother risk-adjusted returns.

Limitations and Criticisms

While diversification return offers a compelling argument for disciplined portfolio management, it is important to acknowledge its limitations and common criticisms.

One significant challenge is the "correlation breakdown" phenomenon, where asset correlation tends to increase during periods of high market stress or financial crises.⁴,³,² During such times, assets that are typically uncorrelated may move in the same direction (often downward), diminishing the protective benefits of diversification and, consequently, the potential for diversification return from rebalancing. This can lead to larger-than-expected losses, as the assumed diversification benefits evaporate precisely when they are most needed.

Another critique relates to the practical implementation of rebalancing. While theoretical models suggest optimal rebalancing frequencies, in reality, transaction costs and taxes can erode some of the diversification return. Frequent rebalancing, while potentially maximizing diversification return, could lead to higher trading costs and taxable events, especially in non-tax-advantaged accounts.

Furthermore, the concept can be misunderstood as a guaranteed "free lunch" in investing. While Modern Portfolio Theory suggests diversification is the "only free lunch," this refers to the ability to reduce unsystematic risk without necessarily sacrificing expected returns. However, diversification return specifically relies on assets deviating from their mean and then reverting, a pattern that is not guaranteed. If assets trend strongly in one direction for an extended period, or if correlations remain high, the benefits of rebalancing for diversification return may be limited. Some experts also warn against "overdiversification," where adding too many similar assets or "faux diversifiers" does not add value and can even dilute returns.¹

Diversification Return vs. Portfolio Rebalancing

Diversification return and portfolio rebalancing are closely related but distinct concepts.

In essence, rebalancing is the active process that enables investors to potentially harvest the diversification return. While rebalancing is primarily a risk management tool to maintain a desired risk tolerance and asset allocation, its effect of selling relative winners and buying relative losers inherently generates the diversification return when assets exhibit non-perfect correlation and mean-reverting behavior.

FAQs

What causes diversification return?

Diversification return is primarily caused by the periodic rebalancing of a diversified portfolio whose underlying assets have different performance patterns (low or imperfect asset correlation). When one asset performs well and its weight in the portfolio grows, rebalancing involves selling some of it. Conversely, when an asset underperforms and its weight shrinks, rebalancing means buying more of it. This systematic "sell high, buy low" across different assets generates the diversification return.

Is diversification return guaranteed?

No, diversification return is not guaranteed. It depends on the relative performance and portfolio volatility of the assets within the portfolio, as well as the discipline of rebalancing. While historical data often shows its presence, especially in portfolios with assets that exhibit mean-reversion, there's no assurance it will occur in all market conditions or timeframes. Factors like high asset correlation during crises can diminish its benefits.

How does diversification return differ from overall portfolio return?

Overall portfolio return is the total return generated by all assets in a portfolio, encompassing capital gains, dividends, and interest. Diversification return is a specific component or additional layer of return that arises from the act of maintaining diversification through rebalancing. It's the incremental benefit beyond what a simple "buy and hold" of the same assets might achieve, especially if those assets drift significantly from their initial weights. It is not always explicitly separated from the total portfolio return but is a result of effective financial planning and disciplined execution.