The Need for Portfolio Diversification


In the most basic sense, investing is an activity whereby individuals or entities forgo current consumption in exchange for consumption in the future. Aside from unusual circumstances, no one would willingly sacrifice more today to receive less tomorrow.

Of course, wrapped up in the overall assessment of gain is the uncertainty surrounding these gains. This uncertainty, generically referred to as risk, comes from many sources and manifests itself in countless ways. Companies, industries, and governments are all subject to both positive windfalls and negative setbacks. Expected outcomes can veer off course due to unexpected changes in inflation, interest rates, input costs, currency fluctuations, competitive activity, consumer sentiment, regulation, innovation, weather events, disease, war, and government policies – both fiscal and monetary.

Although intricately complex and multifaceted, everything in investing ultimately boils down to price. Price is the final expression of tens, thousands, even millions of individuals and institutions weighing in, voting if you will, on the merits of an investment. As a result, price is the most pure embodiment of both expected return and risk. As economic factors change, capital market participants, in aggregate and in real time, adjust prices to ensure expected returns adequately compensate for inherent risks. Importantly, this ongoing dance takes place across infinite dimensions. The merits of an individual security are considered against the attributes (risk and return) of comparable securities – such as one utility stock against another. Likewise, utilities are evaluated against other industries such as technology, healthcare, basic materials, and real estate. Domestic stocks are evaluated against international counterparts. Stocks are assessed against bonds, one country or region versus another, etc. Investment markets, in other words, operate as one massive continuum – a global, ever undulating, investment opportunity set.

So what does this have to do with diversification? Outside of the need to target investor specific risk budgets, to the extent an investor overweights, underweights, or eliminates a company, industry, asset class, country, or currency, they are standing up and proclaiming they know more than the collective wisdom of everyone else. That’s an awfully bold statement. To do so confidently, one must have more/better information, a superior ability to assess risk and reward, or both. In investment parlance, this phenomenon is referred to as “having an edge.” Is this possible? Absolutely. Is this common? One might be led to believe so based on the endless supply of pundits, strategists, and experts that parade themselves on television and across various media outlets. The truth, however, suggests otherwise. In reality, research shows 66% of experts are wrong more than half the time. This fact – worthy of deep contemplation by any investor – is illustrated in the following graphs. The first shows stock market predictions at the start of 2008. In a year when the S&P 500 index was ultimately down 37.0%, these well known firms – filled with bright, educated, experienced, and informed investment minds – were undeniably and disturbingly wrong.

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The story was comparable in 2013, only this time the experts failed to anticipate a stock market return of 32.4%, the strongest since 1997.

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In short, capital markets continuously strive for an equilibrium state whereby the continuum of investment opportunities are priced in such a way that expected returns are aligned with risks taken. Deviation from a diversified portfolio, excluding some assets to own more of others, should be done for targeted risk purposes or in the presence of either superior information or analytical capability. To do so otherwise, however, is nothing more than ignorance, misguided confidence, or misplaced hubris. Moreover, the probability of error and disappointment grows as concentrations become more pronounced in number and/ or magnitude. Absent unusual information, a well diversified portfolio is the best solution to avoid such outcomes.


Getting the timing right is crucial
Notwithstanding the prior section, we now consider the ramifications of company, industry, sector, style, asset class, country, region, or currency bets that deviate from benchmark or “neutral” weightings. These are situations where the capital markets have it wrong and we know so through superior information, insight, or analytical capabilities. While these situations are indeed rarer than commonly believed, perhaps even more problematic is how to play them when they occur. After all, if the world has something fundamentally wrong, there are no assurances things cannot get worse before they get better…..if ever. How long might it take for the rest of the investment world to learn, appreciate, and appropriately price the unique knowledge you possess? How much worse might the distortion become before it is corrected? John Maynard Keynes once said, “The market can remain irrational longer than you can remain solvent.” Indeed, the history books are littered with brilliant portfolio managers and financial advisors that were ultimately proven correct, yet prior to vindication their clients lost patience and their businesses imploded. When it comes to investing, oftentimes being right (hard enough) means little if you cannot also call the timing (often impossible). In the absence of both an information “edge” and a timing “catalyst,” directional bets – i.e. purposeful deviations from a diversified portfolio – are unwise and simply lack staying power.


Uncertainty is the rule not the exception
Even with superior knowledge of a particular investment and an expected catalyst, sometimes the world just gets in the way. War breaks out in the Middle East, Russia invades Ukraine, an election goes the wrong way, tax codes are changed, regulators alter industry dynamics, a deadly disease spreads, central bankers do, or don’t, take expected action, OPEC fails to respond to plummeting oil prices, terrorism strikes, weather causes havoc. The list goes on and on. Life is filled with unexpected curveballs and unknowable binary events. A broadly diversified portfolio will certainly take its lumps from time to time. However, they will be more contained and survivable. Likewise, such a portfolio will inevitably contain investments that actually benefit from otherwise unpleasant or unexpected outcomes. Importantly, these positive positions provide the dry powder to facilitate redeployment of capital into unusually hard hit, and possibly attractive, investment opportunities. The converse is also true. As concentrations increase, the possibility of an unacceptable, if not catastrophic, outcome increases. Eggs start to line up in the same basket. Underlying investment themes often overlap, required economic scenarios become more focused, and the pathway to investment success narrows. Sooner or later, this ends badly.

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Outcomes impact behavior
It is well documented that investor risk tolerance migrates over time. Investors’ perception (i.e. appreciation) of risk changes as well. Here lies perhaps the greatest paradox and arguably the single most destructive reality for investors. Investor beliefs and judgment are heavily influenced by recent experience. As markets rise, investors become more tolerant of risk and their perception of risk diminishes. The converse is also true. While most investors can rattle off the investment cliché of “buying low and selling high,” the truth is people flock to what has gone up and shun what has gone down. Investors, regretful of not capturing enough of the upside, buy more of what has performed well. Conversely, determined to stem the bleeding, investors sell falling markets to end the pain. As shown in the following graphic, chasing markets and selling declines causes investors to achieve dismally poor results.

What does this have to do with diversification? First, having a well-defined, broadly diversified, asset allocation helps to prevent irrational, destructive behavior at market inflection points. Second, this approach ensures an investor will capture some, albeit not all, of the market’s upside and avoid at least some of the pain of the downside. Third, a methodical approach forces an investor to do what everyone readily admits is the goal, but few accomplish in practice. Investors holding broadly diversified, regularly rebalanced portfolios, will sell into market tops and buy into market bottoms. Consistently doing this over time helps an investor not only achieve, but possibly exceed what the capital markets have to offer.


Summary
To many, the appeal of a diversified portfolio is subject to how various asset classes happen to have performed in recent memory. Generally speaking, narrow, one-directional markets driven by one or two key asset classes make investors less patient of the whole concept. This happens to be the case today. The domestic stock market, particularly large capitalization companies, have outperformed the majority of other major asset classes. Many wonder why they owned other things at all and why they should not own more U.S. stocks now. This paper attempts to answer these questions.

  • First and foremost, returns in the past are just that – returns in the past. What only matters to investors presently is returns in the future. Even for experts, returns are unknowable, random, and challenging to predict – particularly over shorter periods of time.
  • To avoid one asset and concentrate in another, an investor must make an accurate forecast using unique information and analytical backup that suggest the market is presently mispricing a particular investment or category of assets.
  • The timing has to be right. The anomaly can’t get much worse and needs to reverse in due course. If investors in aggregate are wrong, their views have to change for a bet to succeed.
  • Unusual, unforeseen risks may uniquely and inordinately impact the chosen concentration more than other foregone investments. This must be anticipated and contemplated. Ignoring the potential of adverse outcomes is naive.
  • The ability to respond to, or survive, adverse events may be limited due to a dearth of positive movements elsewhere in the portfolio (other diversifiers were sold to concentrate).
  • Finally, the investor must possess the intestinal fortitude to avoid selling when things get painful. This last factor becomes an acute challenge (i.e. nearly impossible) when an outsized position goes the wrong way.

The true test of solid financial advice and/or a well built portfolio is neither the ability to meet or exceed the return of the best performing asset class of the most recent performance period, nor is it the avoidance of poor performers. Rather, it is the ability to achieve a reasonable outcome in the face of uncertain events and unknowable outcomes. Eliminating major asset classes, overloading on or avoiding stocks (or bonds), concentrating on particular industries or geographies – these are all glamorous after the fact, when contemplating what could have been. Before the fact, however, when guessing what might be, these types of actions are often problematic if not ultimately self-defeating.

Diversification is the obvious solution.


Disclaimers
This commentary was written by Robert W. Lamberti, CFA, Vice President of Investments and a Principal of Summit Financial Resources, Inc. and Summit Equities, Inc., 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600, Fax: 973-285-3666. Source of performance: Morningstar®. Indices are unmanaged and cannot be invested into directly. The investment and market data contained in this newsletter is not an offer to sell or purchase any security or commodity. Standard & Poor’s 500 Index (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. Past performance does not guarantee future results. Information throughout this Newsletter, whether stock quotes, charts, articles, or any other statement or statements regarding markets or other financial information, are obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the reader. To unsubscribe from this investment newsletter please reply to this email with “unsubscribe” in the subject. Opinions expressed are subject to change without notice and are not intended as investment advice or a guarantee of future performance. Consult your financial professional before making any investment decision.

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