It is well known that diversification is the only real way to increase returns while reducing risk. Normally this risk is measured academically using statistical calculations such as standard deviation. There is another risk that investors must be conscious of when assessing performance: tracking error. Tracking error is the risk your portfolio might perform differently than a particular benchmark. For US investors this normally means comparing your portfolio to the S&P 500. Today we will look at a simple example of two portfolios. One made up entirely of the S&P 500 and one with a 50%/50% mix of the S&P 500 and the MSCI EAFE Index (index containing developed international stocks) rebalanced every year.

The chart below shows the longest period for which I have data – January 1970 to May 2013:

Over this time period the S&P 500 index had an annualized return of 10.2% with a standard deviation of 15.5%. The 50/50 portfolio had an annualized return of 10.3% with a standard deviation of 14.7%. Over the 53-year period, by adding international developed marked stocks to our portfolio we increased our return about 1% while lowering our volatility by 5.5%. Adding more uncorrelated assets to the portfolio would increase this effect.

As I mentioned earlier though, tracking error is a real risk – it causes some to abandon their disciplined, long-term strategy at the wrong time. (The past couple of years of S&P performance, for example, may leave many wishing they just owned 100% US stocks). Below is a chart of the same two portfolios from January 2011 until May 2013:

Over this time period the S&P 500 had a total return of 36.7% while the 50/50 portfolio only gained 24.5%. Those that started investing in January 2011 might be tempted to sell their international allocation and stick with only US stocks. You don’t have to look back too far to find a period where the 50/50 portfolio would have outperformed. Below is a chart of our two portfolios from January 2004 to December 2007:

Here the 50/50 portfolio outperformed the S&P 500 by a total return of almost 25% (66.9% vs. 42.1%). Let’s take a look at two other periods where the returns of these portfolios varied greatly. Below are two charts from January 1985 to December 1989 and January 1995 to December 1999:

As you can see in the first chart (1985 to 1989), international stocks were beneficial to the portfolio. In the second chart (1995 to 1999), international stocks were a drag on returns. Hopefully you are noticing a pattern. There are periods where the 50/50 portfolio outperformed and periods where it underperformed, but over the long-term the diversified 50/50 portfolio should yield the same or higher return with lower volatility.

Adding other assets like emerging market stocks, commodities and REITs will also decrease the volatility of a portfolio, but also increase tracking error. The same goes for tilting your portfolio towards style premiums such as size, value, momentum, and profitability.

Nobody knows what the future holds, including all the talking heads on TV. We might be going through a period where the international markets underperform for many years. International stocks may rally back significantly in the next couple years as well. No matter what your investment strategy, you will always be able to find stocks or indices that have outperformed your portfolio (and ones that underperform). The best plan is to develop an asset allocation you are comfortable with and stick to it. Only then can you really capture the power of diversification.