The Value Project (2): Commit to Diversification

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Many of you have no doubt seen some variation of the famous Stephen Covey presentation wherein Covey puts a bag of small pebbles (representing the less important, perhaps extraneous stuff of our lives) into a container and then has a volunteer try to fit a number of larger rocks in.  These larger rocks represent what each of us decides are the important things to us – but there isn’t room for them in the container.  Then Covey turns it around.  The volunteer puts the bigger rocks in first and only then adds all the smaller ones.  When done in that order, there is room for everything. Covey’s message is both simple and powerful – decide what your priorities are, do the important things first and the lesser things will fall into place.

This idea has important implications for investment management too.  It is crucial that we deal with all of the “big rocks” of investment management before moving on to the less important things.

The total return of any portfolio has three components, which may be positive or negative: (a) returns from overall market movement; (b) incremental returns due to asset allocation; and (c) returns due to timing, selection, and fees (active management). The latest research suggests that, in general, about three-quarters of a typical portfolio’s variation in returns comes from market movement (a), with the remaining portion split roughly evenly between the specific asset allocation (b) and active management (c). To the extent that research differs from that stated above, it concludes that asset allocation is more important and active management is less important.  Therefore, we should spend at least as much time and care in constructing an asset allocation plan as on the investment vehicles used to execute the asset allocation decision.  Establishing an asset allocation plan consistent with one’s goals, investment horizon, and risk tolerance should be the first priority.

The exercise of allocating funds among various investment vehicles and asset classes is at the heart of investment management. Asset classes exhibit different market dynamics, and different interaction effects. Thus the allocation of money among asset classes and among investment vehicles within asset classes will have a significant effect on the performance of the investment portfolio.

Research suggests that allocation among asset classes has more predictive power than the choice of individual holdings in determining portfolio return. Arguably, the primary skill of a successful investment manager resides in constructing the asset allocation, and separately the individual holdings, so as to meet the client’s needs. Accordingly, advisors must consider the degree of diversification that makes sense for specific clients given their risk parameters and construct a list of planned holdings accordingly.

Modern Portfolio Theory asserts that all-inclusive market portfolios (those with broad and deep diversification) make the best trade-offs between risk and reward. More importantly, diversification is best based upon the sources of risk rather than returns.  That is why correlation is so crucial.

The theory behind diversification is simple: Don’t put all of your eggs in one basket. A single holding has huge potential for gains if the right instrument is selected, but even huger risks (because investing “home runs” are so hard to come by).  In general, the greater a portfolio’s diversification, the lower its risk.  Lower risk is a good thing, but only if the portfolio’s potential return is healthy enough to meet the client’s needs.  Fortunately, a well-diversified portfolio captures most of the potential upside available with much lower volatility.

A diverse portfolio – one that reaches across all market sectors – ensures that at least some of a portfolio’s investments will be in the market’s stronger sectors at any given time – regardless of what’s hot and what’s not and irrespective of the economic climate. At the same time, a diverse portfolio will never be fully invested in the year’s losers. For example, according to Morningstar Direct, about 25% of U.S. listed stocks lost at least 75% of their value in 2008 but only four of over 6,600 open-ended mutual funds lost more than 75% of their value that year. Thus a diversified approach provides much smoother returns over time (even if not as smooth as desired!).

Accordingly, portfolio diversification requires careful management of the correlations between and among the asset returns and the liability returns, issues internal to the portfolio (the volatility of specific holdings in the portfolio), and cross-correlations among these returns. With day-to-day volatility very high and correlations remarkably high too (see the chart immediately below), diversification is now more valuable than ever.

Source: Bianco Research

The table immediately above will be familiar to most of you.  It shows the annual returns of various asset classes over the past 20 years.  Most people pick investments based upon what is “hot.”  If, from 1991-2010, one had invested in the previous year’s top performer, s/he would have received 3.88% average annual returns.  But since investing tends to be mean reverting, a smart contrarian who invested in the previous year’s worst performer would have averaged returns of 10.91%. Even so, an investor who created a more diversified (if not optimal) portfolio of 45% domestic large cap stocks, 10% domestic small cap stocks, 10% international stocks and 35% aggregate bonds would have seen average annual returns similar to those earned by the contrarian (9.66%) but much lower volatility (12.61% versus 21.32% for the contrarian). 

The key advantages of broad and deep diversification, then, are the capture of a healthy share of available returns, smoother portfolio performance and thus less volatility.  Especially in a secular bear market like the one we have been suffering through since 2000, those are worthy goals.

 

The Value Project

The Value Project (2): Commit to Diversification

The Value Project (3): The Value Proposition

The Value Project (4): Emphasize Process

The Value Project (5): Other Stuff

The Value Project (6): Recognizing Value