Templeton offers colourful lesson in diversification

There's a fascinating poster that Franklin Templeton Investments has just mailed out to investment advisors.

It's titled "Why diversify?" and shows a grid of the investment returns from various asset classes between 1984 and 2004. If you don't have access to the actual poster you can find it here.

Even if you've seen a similar chart before, I can think of no more effective primer on investing. It shows at a glance that in any given year, a particular asset class may be the top performer and another asset class may be the worst. But a year later, the relative positions may reverse.

In fact, this is exactly what happened in 1999 and 2000. In the last year of the roaring 1990s bull market, Emerging Market equities roared the most, with a 57.2% return. Trailing all major asset classes in 1999 was Canadian bonds, with a 1.1% loss.

When the bubble burst in 2000, the tables turned. By year-end Canadian bonds led the field with a 10.3% return. And you guessed it, Emerging Markets fell to the rear in the race, losing 28.2%.

Hindsight is, of course, 20/20. But how useful is such a chart in helping investors plan for the future?

Let me issue a challenge. Ask your financial advisor for a copy of this poster, or download it. Scrutinize it for 15 minutes and try to find a pattern that will help you predict what will do best in the future.

If you are able to accomplish this, dash off a private e-mail to me and we'll make our fortune together.

The point is it's next to impossible to find any pattern in the past 20 years that will have any predictive value for the next 10 or 20 years. The rise and fall of different asset classes appears to be totally random.

Franklin Templeton's conclusion is that investors must remain invested in all the major asset classes at all times. On the poster, to the right of the grid is a smaller set of three bar charts entitled "Diversification Outperforms." It shows that a strategy of diversifying across all asset classes beats a "chase the losers" strategy and either strategy beats the typical mutual fund investor's attempt to "chase last year's winners."

How big a difference does this make? A $10,000 investment in December, 1984, grew to $766,720 by December, 2004, by diversifying, to $559,247 by chasing losers and just $521,601 by chasing winners.

Here's how you can spend a good half-hour with this chart and come out the wiser. Pick a given asset class -- say U.S. large caps -- and track it over the 20 years. In this case, the chart colour-codes U.S. large caps as bright yellow. Start with 1984, and put your finger on the yellow square. Move to 1985, doing the same thing and proceed gradually to the right, ending in 2004.

Your finger will move up and down like a yo-yo. You'll see that from 1995 to 1998, U.S. large caps were the best asset class, with returns of more than 30% in each of 1995, 1997 and 1998. You'll also note that in the last three years, from 2002 to 2004, they were the worst asset class. (Contrarians, take note!)

Now do the same thing with U.S. small caps, which are colour-coded a pale yellow. The pattern is equally random: Some years, small caps beat large caps, other years it's the reverse.

Next, pick Canadian bonds, which are purple in the chart. These topped the charts in 2000 and 2002 but were the worst asset class in 1999 and near the bottom in 1993 and 1994.

Finally, track the progress of Canadian large-caps (red) and Canadian small-caps (pink), and end with global equities, global small caps and emerging market equities.

If this exercise is not as enlightening as it is entertaining then you're not really an investor. Either that or I have no life.

If I have a quibble with this chart, it's that it's too heavy on equities. Of the nine asset classes used, all are equities except Canadian bonds. They also include both global equities and international (i.e. EAFE or non-North American equities) but fail to include some significant alternative asset classes, such as global bonds, gold or commodities, income trusts, corporate bonds, Real Return Bonds or hedge funds. Now that's a chart I'd like to see.