The Diversification Debate

Abnormal Returns is one of my daily must-reads (my “Daily Dozen” must-reads is here). AR acts primarily as a trusted curator of financial information, allowing me to be much more efficient with my time. 

This morning, AR highlighted the “diversification debate.”  On the one hand, it cited Howard Lindzon for the proposition that “diversification is overrated.”   On the other hand, it cited Carl Richards and the Bucks Blog for making the pro-diversification argument. As per usual, AR remains neutral (it’s a “forecast-free investment blog,” after all):  “[B] oth pieces are worth reading in their entirety.  Allow me to split hairs here.  Carl is correct that a broadly diversified portfolio is the best solution for the vast majority of investors.  Howard’s advice is targeted more towards intrepid investors, like himself.  In that sense both bloggers can be correct.”

Allow me to elaborate.  Professionals won’t find anything new here, but individual investors may.

Richards is an advocate of index investing.  As such, diversification is the be-all-and-end-all of his strategy.  An indexer wants his or her overall portfolio diversified and the individual components of it diversified.  As his post points out, a broadly diversified 60/40 index portfolio including large, small, real estate, international and emerging markets stock indices and a broad bond market index returned far more than the 1.4% annually, including dividends, returned by S&P 500 alone from 2000-2010.  Indeed, such a portfolio — an index portfolio comprised of multiple indices — returned an average of nearly 8% annually for that same period.  As Richards emphasizes, that’s hardly the “lost decade” many have complained about.

Lindzon doesn’t elaborate on his statement, but I think his meaning is clear.  By definition, active managers have clear points of view with respect to what is rich and what is cheap.  Concentration on selling what is richest and buying what is cheapest is how active managers go about trying to beat “the market” (and it is usually an index that benchmarks whether they have done so).  Diversification means that an active manager is in reality a “closet indexer” and, on account of fees, will find it essentially impossible to beat the market long-term. Active managers want concentration rather than diversification.

That said, even the best and most successful investors make mistakes and have down periods— which can last a significant period of time.  This problem is particularly acute during secular bear markets.  The current one began in 2000.  They last, on average, about 17 years.  During these secular bear markets, equity markets are prone to strong cyclical swings in both directions.  In 1977, during a previous secular bear market, Time magazine called this phenomenon a “roller-coaster to nowhere.”  At such times, an investor’s primary job is to preserve capital. Accordingly, investment portfolios during these periods should be diversified across a range of investments that are diligently selected and carefully managed so as to control risk first. Only then should they seek to enhance return. Such portfolios should actively seek investments which are not correlated to the broader market so as to manage risk and to provide opportunities for enhanced risk-adjusted returns. 

In this setting, diversification is designed to lower risk and smooth returns.  Thus, within one’s overall portfolio, diversification is a key goal even if it is not a goal of the components of the portfolio.  Those individual components might be highly concentrated (such as, for example, a significant allocation to a concentrated value investment vehicle).

Like Billy Martin in the old Miller Lite commercials, it is possible to feel strongly both ways.

6 thoughts on “The Diversification Debate

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