Goldilocks Diversification

Any children’s laxative commercial with the tag line “Better Than Prunes” and featuring “Little Miss Irregular” has to be memorable and this classic Fletcher’s Castoria ad from my childhood is all of that and more.

 

The question about prunes – “three enough, six too many?” – is a crucial one indeed for parents everywhere.  Yet it also portends profound investment implications too:  How much diversification is enough and how much is too much?  We all want Goldilocks (“just right”) diversification even though it can be very difficult to achieve.  But before we tackle the question of how much is enough but not too much, let’s briefly review why diversification is so important.

The concept undergirding diversification is simple: Don’t put all of your eggs (or prunes) in one basket. A single holding has huge potential for gains if the right instrument is selected.  We all wish we had bought a big slice of Apple early on.  But for every Apple there is at least one Enron.  Moreover, success of that magnitude has as much (or more) to do with luck as it does with skill.  As Dick Morley carefully points out, generally speaking, an angel investor or venture capitalist with a 20 percent “hit” ratio is doing very well even though s/he thought that each of the failures (eight out of ten!) was a good – perhaps great – idea.  Good ideas fail all the time.  Add factors like incompetent management, fraud and the business cycle to the mix and the risks are both obvious and enormous.

Moreover, some incredible successes are almost entirely random.  Viagra was a heart medication with interesting side effects.   Plastic was first synthesized in a failed effort to replicate a shellac made from beetle husks.  An engineer was experimenting with military radar systems when he noticed that a candy bar in his pocket was melting and the microwave oven was born. The blood-thinner Coumadin was originally a rat poison.  Penicillin was an unexpected byproduct of moldy bread. What became Super Glue was supposed to be a clear plastic gun sight.  Potato chips were invented by a spiteful chef angered by a diner complaining that his french fries were too thick.  Diversification allows for serendipity.

You get the idea.  Diversification is a good thing because investment success is so uncertain and because it lowers risk.  Thus a well-diversified portfolio captures most of the potential investment upside available with much lower volatility.  Let’s quantify the concept quickly.

The table 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 percent 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 percent. Even so, an investor who created a more diversified (if not optimal) portfolio of 45 percent domestic large cap stocks, 10 percent domestic small cap stocks, 10 percent international stocks and 35 percent aggregate bonds would have seen average annual returns similar to those earned by the contrarian (9.66 percent) but with much lower volatility (12.61 percent versus 21.32 percent for the contrarian). 

The key advantages of diversification, then, are the capture of at least 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.  Indeed, if one is a passive investor, we’re essentially done.  For passive investors, the goal should be the broadest diversification possible: exposure to the entire market.  For them, there is no such thing as too much diversification.  In my view, that’s an appropriate investment default.  A passive investment approach using low-cost index funds via dollar cost averaging would provide significantly better investment results for the vast majority of investors. 

But investors looking to “beat the market” (difficult though that is) or who have other needs/desires (such as gaining better risk management, seeking investment or behavioral discipline, or managing complicated tax or estate issues) will need to do more and that gets us to our quest for Goldilocks diversification.  If our positions aren’t numerous enough, our risk of disaster is too high.  On the other hand, too many positions means too little room for distinction (in Warren Buffett’s words, it’s “protection against ignorance”).

Most actively managed funds are highly diversified and cannot be expected to outperform.  The average number of stocks held in actively managed funds is up roughly 100 percent since 1980, according to data from the Center for Research in Security Prices. See Pollet & Wilson, “How Does Size Affect Mutual Fund Behavior?” Journal of Finance, Vol. LXIII, No. 6, p. 2948 (December 2008). Large numbers of positions coupled with average turnover in excess of 100 percent (per William Harding of Morningstar) effectively undermines the idea that such funds could be anything but “closest indexes.”  It makes no sense to incur the excess costs and to suffer the tax inefficiencies of active management to purchase an investment that is, in effect, a closet index.

Numerous studies show that funds which are truly actively managed and more concentrated outperform passive management and do so with persistence.  See, e.g., Kacperczyk, Sialm & Zheng, “Unobserved Actions of Mutual Funds” (2005); Cohen, Polk & Silli, “Best Ideas” (2010); Wermers, “Is Money Really ‘Smart’? New Evidence on the Relation Between Mutual Fund Flows, Manager Behavior, and Performance Persistence” (2003); Brands, Brown & Gallagher, “Portfolio Concentration and Investment Manager Performance” (2005); and Cremers & Petajisto, “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” (2007).  As summarized by Cremers and Petajisto:

Funds with the highest Active Share [most active management] outperform their benchmarks both before and after expenses, while funds with the lowest Active Share underperform after expenses …. The best performers are concentrated stock pickers ….We also find strong evidence for performance persistence for the funds with the highest Active Share, even after controlling for momentum. From an investor’s point of view, funds with the highest Active Share, smallest assets, and best one-year performance seem very attractive, outperforming their benchmarks by 6.5% per year net of fees and expenses.

This approach has practical benefits too in that the resources devoted to the analysis (original and ongoing) of each specific investment varies inversely with the number of investments in the portfolio.  I generally favor a carefully delineated and bounded process with clear execution rules and a long-term commitment.  This process should focus on making enough “bets” within our favored approaches (such as value, momentum and low beta) and market sectors (such as global and small cap) to mitigate risk and to provide the best likelihood of success overall while limiting investment enough to avoid closet indexing.  Moreover, as Warren Buffett argues, “a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.” My working hypothesis is that 20-40 positions within a given approach or sector is the right amount generally but I remain open to being shown otherwise.  I emphasize the tentative nature of this approach both because more research is needed and because constant monitoring is always necessary in that what works today will not necessarily work tomorrow.

Note, however, that diversification within investment approaches and portfolios is distinct from diversification of investment approaches and portfolios. My working hypothesis here is generally to utilize 5-6 investment approaches and portfolios with allocation amounts predicated upon market action and trends.  My starting point is Meb Faber’s Spring 2007 Journal of Wealth Management paper, “A Quantitative Approach to Tactical Asset Allocation.”  I then seek to tweak those allocations via other quantifiable probability analyses (see James O’Shaugnessy’s What Works on Wall Street) overlaid with various market valuation measures (not just one or two) to remain cognizant of the “long cycle.”  In the current secular bear market I also encourage the use of portfolio hedging.  This approach is not without difficulties and demands further testing, but it is the overall approach to asset allocation I favor now.

It’s a common maxim that diversification is the closest thing to a free lunch offered by the markets.  Having too little diversification is a common and well understood problem.  Having too much is a less well understood problem.  Finding the Goldilocks just right level of diversification of and within market sectors and approaches as well as within investment portfolios remains a constant challenge.