A Conversation on Diversification

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Investor education has improved substantially over the last two decades such that the average investor is aware in a broad sense that they want a “diversified” portfolio. They understand that being diversified reduces risk. But, that’s only scratches the surface of the importance of diversified portfolios. What follows is a conversation I’ve had dozens of times with people getting to the heart of this issue.

I want my portfolio to be diversified, but what does that really mean?

Most people have heard that they should be invested in “diversified portfolios.” They’re right, but what does that really mean? At its most basic, diversified portfolios try to take advantage of the phenomenon of “uncorrelated investments.” Imagine Stock A and Stock B which move in a perfectly mirrored pattern such that when one zigs the other zags, and vice-versa. Together, they would smooth each other out to create an overall performance of gently upward sloping growth with no declines in value whatsoever. We would all love a portfolio that looked like this. Unfortunately, it’s not this simple. For example, in 2008, there were almost no stocks that zigged as the rest of the stock market zagged—sometimes, everything moves together.

Then what good is a diversified portfolio?

Building a diversified portfolio is about separating systematic risk from unsystematic risk. Systematic risk is the risk of the “market”—that is, when the stock market as a whole goes down, your portfolio goes down. This risk can never be removed from investing. But unsystematic risk is the risk that an individual company will fail—like Enron in 2001. This type of risk can be controlled. Not by being so smart you don’t invest in bad companies, but rather by buying so many companies one company’s failure won’t have an outsized effect on your portfolio as a whole. Every day companies in the stock market are falling in value just like Enron—but if you own a thousand different companies, then your portfolio will still reflect the market as a whole. You win some, you lose some and you earn the average – which is the market.

But I don’t want to earn “average,” I want to earn “above-average!”

If we define “average” as the “overall stock market” then there are two different ways of looking at “above-average.” The first way is the most obvious—I want to earn more money than the average of the stock market. The second way is less obvious, but perhaps more important—I want to earn the same amount of money, but I want less “ups and downs.”

Let me address the first connotation with this: It is very hard to earn more money than the stock market. There are two primary ways in which people attempt to earn more money than the stock market: 1, selecting a few “outperforming” stocks and hoping that they do better than the market as a whole (commonly referred to as “picking stocks”); and 2, “timing” the market by guessing when the market will go up and when it will go down and buying and selling out of and into the market in such a way that the portfolio is only invested when the market is going up. Academic studies have repeatedly demonstrated that neither of these options are successful over the long-term.

Selecting a few stocks exposes investors to the risk that their “outperforming” stocks will perform just like Enron: moving up, until one day they move down so quickly that an investor is wiped out. If you selected a lot of “outperforming” stocks to prevent an Enron-type situation from wiping you out, then all you’ve really done is build a diversified portfolio. In fact, Burton Malkiel, one of the early pioneers of diversified investing, demonstrated in the 1950’s that a portfolio of only 15 randomly selected stocks performs comparably to the market as a whole. And as investing has become more cost-effective with Mutual Funds and ETFs, you may as well own a 1,000 stocks rather than 15.

The other option to outperform the market is to try and make predictions based on when the market will go up and down. The problem with this approach is that every time an investor buys and sells out of the market it costs them money. Every time an investor sells stocks, they pay a commission and in taxable accounts, they pay capital gains taxes. Furthermore, academic studies have shown that the average advisor is not capable of predicting future market movements in a way that increases the return. They can get out sometimes when the market is down, but they’re also sometimes wrong and the market goes up. The average ends up being comparable to the average market return—except that it’s less because they’ve spent a lot of money in commissions and taxes.

So if picking stocks and timing the market don’t make my portfolio “above average,” is there anything that can?

Yes, but not in terms of performance, rather in terms of risk. This gets back to the less obvious idea that a portfolio which earns comparable returns to the market but with less “ups and downs” (or volatility) is an above-average portfolio. Imagine for a minute that you could build a portfolio that earns the same amount as the stock market, but when the stock market declines by 50%, your portfolio only declines by 30%. Most people would consider that an “above-average” portfolio.

Sadly, there is no way to earn the same amount as the market with less risk. But, a well-constructed, broadly diversified portfolio that leverages asset-class investing and target-based rebalancing can absolutely deliver a portfolio that earns more than the market per unit of risk.

Diversified portfolios are typically constructed as a mix of stocks and bonds meant to deliver a specific level of risk. i.e. a portfolio with a lot of bonds will get less return, but will be very stable and a portfolio with a lot of stocks will get more return, but will be very volatile. Our instinct is to think of portfolio construction as a straight-line trade-off between risk and return, like the straight, dotted line between the 100% T-Bills and 100% US Stocks in the graph below.

In fact, years of academic evidence have demonstrated that a well-constructed portfolio diversified among asset classes delivers performance that instead looks like the graph below. The curve of the line rather than a straight line shows that you get a small incremental return for the same level of risk. The portfolios we build are in fact, “above-average” as measured by the historical return relative to the total volatility.

diversificationeffect

Okay, you’ve sold me on diversified portfolios. But what makes your diversified portfolio different than the next guy’s?

There are five key pieces that make us unique.

  1. Cost
  2. Asset Allocation
  3. Target-Based Rebalancing
  4. Tax Management
  5. Cost again

Please read our next installment for a detailed description of these five key pieces…