15 May 2024 3 min read

Diversification for the win

By Bruce White

We're just a few months away from the Paris Olympics, so what better time to shoehorn in a sporting slant on portfolio analysis?


The following is an extract from our Q2 Asset Allocation outlook.

Our portfolio Olympics pits four natural resource asset classes against one another, vying for gold, silver and bronze medals, as well as a wooden spoon for last place. The contenders are Gold Miners, Silver Miners, Copper Miners (as the key ingredient in bronze), and timber and forestry companies (‘Wood Choppers’).

For the first head-to-head race, we examine the realised geometric return on each of those asset classes over the longest common period we have for those indices:[1]

It is clear on this geometric return race that the Wood Choppers win gold, copper silver, gold bronze and silver takes the wooden spoon. Simples. Or is it?

Realistically, we aren’t looking to allocate 100% to these asset classes. More likely, they will receive just a small slice of the portfolio, and to keep it straightforward the remainder will be in global equities. Let’s say that is 2% for Wood Choppers, scaled down for the miners in proportion to their much higher volatility.

The table below evaluates their usefulness as ‘team players’, that is a portfolio’s return including a monthly rebalanced slice to each index and global equities.

The differences are small, as you would expect from just a small allocation. But in the photo finish for the impact on portfolio return, gold now wins gold, copper silver, silver bronze and wood wood.

Why? How do gold miners manage to juice up portfolio performance when they weren’t the best performing?


Digging deeper

A look at the other characteristics of the asset classes reveals why. All have high volatility compared with equities. That high volatility causes higher arithmetic returns (the simple average of returns in each time period). Compare an asset that falls 10% then rises 11.11% with an asset that falls 50% then rises 100%. They have the same geometric return, but the latter much higher arithmetic return.[2]

When we look at a rebalanced allocation to those assets we are interested in arithmetic returns, as we take a weighted slice of each arithmetic return to add to the overall portfolio’s arithmetic return.

So, adding in an asset with high arithmetic return will boost the arithmetic return of the overall portfolio. That will boost the geometric return of the overall portfolio if the addition compensates for any volatility increase in the portfolio from adding in that asset. This is the ‘diversification bonus’ for an asset.

Looking at the first table, gold miners have a lower arithmetic return than copper miners, but the latter has a high beta, so adds to portfolio risk. An asset class with high, idiosyncratic volatility is better all else equal for adding to a portfolio’s geometric returns. Though portfolio return-to-risk ratios will only improve for relatively incremental allocations.

The conclusion from this isn’t anything in particular about those specific asset classes; instead it’s that geometric returns are an incomplete lens when evaluating potential asset classes in a portfolio context.

The volatility and beta to the portfolio matter from both a return perspective, especially for high-volatility assets, as well as the risk impact.

It should be noted that diversification is no guarantee against a loss in a declining market.

The above is an extract from our Q2 Asset Allocation outlook.


[1] Indices used are MSCI World Developed USD, Solactive Pure Gold Miners USD TR, Solactive Silver Miners USD TR, Solactive Copper Miners USD TR, S&P Forestry & Timber Index USD TR. Data source: Bloomberg L.P. as at February 2024.

[2] The approximate relationship is that geometric average return is equal to the arithmetic average of returns less half of the square of volatility (standard deviation).

Bruce White

Fund Manager

Bruce is your not-so-Aussie Australian. While seemingly laid back, this serious(ly deadpan) fund manager likes to have trades lined up before most of the team have come in and is not impartial to a little mental acrobatics when it comes to powerpoint slide creation. His socks can be rather colourful…as can his language…

Bruce White