Image by u m a m i via Flickr
People say diversification is the only free lunch on Wall Street. By this they mean that if you properly diversify your portfolio you can reduce the risk of your portfolio without necessarily reducing the expected return. This is a powerful mathematical concept. What is diversification? It means that for every stock that you buy and add to your all-stock portfolio you have a good likelihood that it will add return as well as reduce risk or some combination of the two. In any event adding more stocks to an all-stock portfolio is a good thing. As a student of finance and as a financial practitioner I completely embrace the claim diversification makes and you should as well.
In this tale, I want you to eliminate everything except stocks from the diversification discussion. My focus on diversification will be limited to that of an all-stock portfolio. Of course everyone knows that a portfolio gains diversification when asset classes other than stocks are added to it, but in this tale I am trying to isolate the effect of the stock component of your portfolio only. It is critical. Furthermore, I consider the addition of asset classes such as bonds, cash, real estate, or commodities to an all-stock portfolio as more of an asset allocation decision than a diversification decision. The two concepts of diversification and asset allocation are so intertwined that it is difficult to know where one ends and the other begins. However, they are very different. Investment diversification is a mathematically precise derivation and asset allocation is a theory. Diversification is robust while asset allocation is untested.
Incidentally, I don’t espouse the use of real estate or commodities in my asset allocation models. I think it’s a form of self-delusion to think that these two asset classes will protect the investor during turbulent times. My research indicates that when markets are turbulent, this means when they are going down, that there is no safe shelter other than cash or bonds. As we see the events of 2008 play out we can witness that the asset allocation theory where practitioners have included real estate and commodities in their portfolios did not work out. It might work for the next 50 years but it did not in 2008 and it won’t the next time there is major turbulence. Nevertheless, I will explore the subject of asset allocation in An Asset Allocation Tale.
Is there a limit to the benefits of adding stocks to a portfolio? The answer is yes. There is a limit or point of diminishing return where adding another stock does very little to either increase return or reduce risk. When you reach this point you theoretically have a diversified portfolio. Because there are so many ways to construct a diversified portfolio of stocks and because Americans have a compulsive need to measure things they had to create a stock market benchmark or measuring stick. The first and to this day still most recognizable benchmark or index is the Dow Jones Industrial Average, or DOW. Since then we have progressed to bigger and more encompassing indices or benchmarks such as the S&P 500, Russell and others. Ironically another American trait is to overdo a good thing and soon we will be to the point where there will be more benchmarks than individual stocks that make up these benchmarks. But for purposes of this tale let’s say that the S&P 500 is the best measure of performance for the stock market.
We know that if you properly diversify your portfolio you can reduce the risk of your portfolio without necessarily reducing the expected return. You do this by adding stocks to your portfolio. We also know that when you construct what you think is a diversified portfolio of stocks you will measure it against a diversified portfolio of stocks called the S&P 500. The question then becomes is there a way to construct a diversified portfolio of stocks that has better characteristics than the S&P 500? Can we build a portfolio that makes us more money with less risk, or more money with equal risk or maybe less money but substantially less risk? These are the questions that everyone asks. It’s good to ask these questions because it shows that you are thinking but once you delve deeper into the concept of diversification you will learn that the answer in most cases is no. If you have a diversified portfolio of stocks then by definition it will behave like the stock market, which in this case is represented by the S&P 500. This means that if you own a diversified stock portfolio by definition you own a basket of stocks that acts like the entire universe of stocks.
So at first we were happy to hear that diversification is Wall Street’s version of a free lunch but now we’re not so sure we want to accept the invitation. Diversification sounds wonderful but it’s misleading. It’s incomplete because it doesn’t take people’s behavior into consideration. Diversification is a double-edged sword. What’s the problem with diversification? Diversification doesn’t allow for spectacular returns and many people want spectacular returns because, you guessed it, they think they are spectacular.
To make spectacular returns you must concentrate, overweight or trade your portfolio. A concentrated, over-weighted or traded portfolio is the antithesis of diversification. It means putting all or a substantial portion of your money in the best performing investment opportunities that you envision. This is the way that most great fortunes are made. These fortune builders put all or most of their eggs in one basket by starting a business or investing in a small company that grows to a large company. This is an all-or-nothing strategy however and when they are wrong they end up on the Nothing end of the rate of return spectrum instead of the All. We only hear about the Alls but rest assured that the Nothings far exceed the Alls. Diversification assures that you will be somewhere in between All-or-Nothing.
This brings us to the critical issue about diversification and one that is seldom discussed in the financial literature. The question to diversify or not is the question that every investor faces. It is unavoidable. This tale is not about telling you how to diversify a stock portfolio, you can do that in 1 minute by picking up the phone or punching in a buy order for a mutual fund or exchange traded fund that buys the S&P 500. Diversification in America today is easy. The choice is not. This tale focuses on the question to diversify or not? That is the central question of diversification, not the how to. Because you must choose to diversify, you are the integral component of your portfolio. How you behave matters.
Lets look at where we are as of this writing with regards to stockmutual fund investing. We see that approximately 20% of the assets that are invested in the United States are invested in low cost index funds or exchange-traded funds. These types of investments that just buy the S&P500 or other well known indices are called passive investments because they don’t require an expensive portfolio manager or what I call a Hired Asset Manager or HAM. People that choose to invest this way are called passive investors. Where’s the other 80% invested? The remaining money is invested in active investments that require the skill, expertise and expense of an active manager or HAM. People that invest this way are called active investors and the HAMs are called active managers. Unfortunately, the two terms alone, passive and active, are enough to see where this takes us. Do you want to be passive or active? Given this choice I would vote active. After all isn’t active better than passive? Don’t we all want this? Aren’t we taught this from birth? The correct answer is passive however. There is no evidence that active management outperforms passive management over the long run.
This 80/20 dichotomy is perplexing. How can it be even after 20-30 years of academic research that preaches the futility of active management that more people choose active management over passive management? Certainly the terms active and passive have something to do with it. If I were running an index fund company I would work on changing how my indices are branded. I would rephrase the question is active better than passive to is a “Favorite” more likely to make you money than a “Long Shot?” Would investors change their answers? What if I were to say that there are two ways to invest in stocks. If you bet on the “Favorite” every time you will over time make the same or more money than 95% of the people that bet on the “Long Shot.” If the question were phrased this way you wouldn’t see 20% of the people investing in the “Favorite” and 80% investing in the “Long Shot” as we do today. The percentages might in fact be reversed. This is a better way to think of diversification. If you are passive, if you bet on the “Favorite”, if you diversify you will more than likely be far better off than if you don’t. Yet we can observe that people don’t invest this way.
Why don’t we see this type of rational behavior when we examine the facts? One reason is people are sold active investments because they are in the best interest of the salesman, sales driven advisor or SAD. A second is lack of education. This tale educates you. The last reason and perhaps most misunderstood is because of human behavior. In cultures such as America’s where people think they are special it is difficult for someone to say that they must be satisfied with average results. It seems un-American to think that as an investor you will be average. Research in the field of Behavioral Finance shows that over-confidence or entitlement plays a major role in the poor returns that most people experience. People reject diversification and choose active management because even after I or someone else tells them the realities they still think it’s the other guy that is going to lose, not them.
Let’s extend the definition of diversification to include what we’ve learned. We can now say that if you properly diversify your portfolio you can reduce the risk of your portfolio without necessarily reducing the expected rate of return, that you will outperform or equal at least 95% of your fellow investors, that you will never make extraordinary returns but that you will make about the same returns as others that choose to diversify. Let’s focus on the phrases expected rate of return and the same return as others that choose to diversify. As you diversify your portfolio your returns will resemble the returns of S&P 500. In fact it may be exactly the S&P 500, which is available for purchase in its entirety. This means that for the 20% of investors that own passive investments today, if the expected rate of return for the stock market is 10-12% per year on average, they will make these returns.
Choosing diversification makes you average amongst other investors that choose diversification as well. It presents a paradox however. How can a group of people that choose to be average make higher rates of return than those that don’t. Are they smarter? Are they more educated? Are they more self-aware? Do they know something we don’t know? We know from decades of stock market research that when one chooses to be average, when one diversifies, actual long-term performance translates to way above average performance since most individual investors as well as active professional portfolio managers never come close to achieving long-term returns of 10-12%. In people’s quest to be above average they fall below average and in many cases way below average. It’s of note that in any given year, about 80% of active, professional, highly compensated portfolio managers fail to outperform those that simply invest in the S&P 500. Active management is a losing game for individual investors as a whole. It can be won as many have proven but overall it’s a bad bet because even when you win you win by so little that it’s not worth it.
So is diversification a free lunch? The answer is yes if you want it to be because all are welcome. Diversification welcomes the entire spectrum of investors from expert to novice. It’s a bet on the “Favorite.” In a very democratic fashion, diversification doesn’t discriminate; it offers the novice the same expected rate of return as the expert. The novice will never get better investment odds anywhere else. Let’s be clear, it is not the goal of investing. The goal of investing is to increase the purchasing power of your money. Diversification is a technique that you would use to achieve your goal and one that most people should use and that I recommend. It is a portfolio state but before it can be a portfolio state it must be a state of mind. A diversified portfolio doesn’t happen by chance. It is not a random event. It is a conscious decision that an investor makes and makes every day since it is also so easy to reject diversification after you have started down the path.. However, be certain that you will never achieve extraordinary returns with a diversified portfolio. To achieve extraordinary returns you must by definition choose to not diversify. The choice is yours. Choose wisely. Recognize that throughout history anyone that has ever achieved extraordinary returns did not do it by diversifying.
Let me try to influence your choice. Let me give you a thought to ponder. One of the largest and most successful money management firms in the world is Fidelity Investments. People that know baseball will know that Yankee Stadium was called “The House that Ruth Built.” I call Fidelity Investments “The House that Peter Lynch Built.” Peter Lynch is the legendary investor that managed the Fidelity Magellan fund and racked up the best mutual fund performance of his generation. He was the Babe Ruth of mutual fund managers. He has been retired for almost fifteen years and my question to Fidelity and others is, where is the next Peter Lynch? When the payoff for the firm that finds, creates or nurtures the next Peter Lynch can be counted in the billions it begs the question where is the next Peter Lynch? I can’t find him and either can Fidelity and others.
Clearly these firms have resources that an individual investor doesn’t have and yet they have met failure after failure in their pursuit of a superstar money manager. These large money management firms have infinite resources devoted to discovering the next great money manager, yet they can’t. Once again, despite all their resources they can’t find another star money manager to take them to the next level of profitability. With that in mind, I find it difficult to believe that if they can’t when they have billions of dollars of profits as an incentive, that the individual investor picking active managers from their living room can achieve spectacular results. It’s laughable. I also find it laughable to think that if Fidelity and the rest of the mutual fund establishment can’t find these managers that people buy into the concept that a SAD at a full service brokerage firm such as a Merrill Lynch or Smith Barney or Wachovia can find private money mangers for the individual investor. I think the choice for most people is simple—–insist that either you or your advisor construct a diversified portfolio of low cost index funds and focus on designing an asset allocation model that accommodates your risk threshold for a large portion of your portfolio.
HOME / AUTHOR BIO / FINANCIAL TALES / RESOURCES / WHITE PAPERS
Pingback: Newly Released Tales - Inauguration Day « Financial Tales
Pingback: Interview with Meir Statman – What Investors Really Want | Financial Tales
Hello,
My name is Christine Kim, and I am an Economics student currently studying a year abroad at Sciences Po. I read your blog on Diversification, and I was wondering if you’ve read The Economist’s blogger Buttonwood’s All in the Same Boat blog post? He talks about diversification, too, and if I’m not mistaken, you seem to have a different view. He makes the point that in our world of globalisation today, diversification is not diversification because the global market is becomng more correlated. Thus the intent of diversifying (reducing risk by spreading assets) seems moot because having stocks in Korea won’t help any when US stocks go down because then that affects Korea’s stocks negatively too. But you still hold that diversification is a good move, right?
I was just wondering, then, how you would respond to his blog? Do you think diversification itself is now moot, or just the WAY in which people are diversifying, or do you have a different opinion altogether? I ask this because I believe that people aren’t really diversifying, but rather putting all their eggs in developed markets’ baskets–as you say, they want extraordinary returns, which today seems to mean investing in the rich rich countries–and in turn, this means that they are, indirectly, fueling what I see as “bad globalisation”, globalisation based on 1) developed markets getting their prosperity by various unsustainable means, such as multinational corporations outsourcing their labor to cheaper countries and exploiting resources there (linked to what people call a race to the bottom), or 2) emerging markets pinning all their hopes on revenue based on high consumption rates of developed countries, instead of focusing on a more widespread consumer base, etc.
I don’t know if I’m making sense or not…basically, do you think there’s a way to diversify AND avoid this correlation that Buttonwood talks about?
My email is below; I’d love for a response!
God bless,
Christine
Christine,
You ask a complex question which has no right answer. You must always go back to the basics when thinking about stock markets and ask what diversification says it can do for you. Let’s define it and what it states it can do in simple terms—it either increases return for a similar risk or maintains return for a lower risk. In this strict sense diversification works, will work, has always worked and will always worked. The math on this has been proven many times before. So you aren’t really asking does diversification work—of course it does what you are asking is does it work as well as it has in the past. The answer is no it hasn’t. However, we are investors and while investors can see perfectly in hindsight we can’t invest back in time, so your question should be forward looking and ask will it work into the future and to what degree. Specifically your question should be focused on what degree will it work and is where your questioning on correlation coefficients is coming from.
If you are asking are stock markets more correlated today than yesterday than the answer is yes on the three time frames I analyzed which are short, intermediate and long term time frames. If you ask will stock markets stay at these levels of correlation into the future or will they get more or less correlated–I would bet more or less and if I had to choose one I would bet less. But let’s look at the last few years and analyze.
If you look at long term stock market correlations ( my preferred actionable time frame) for 3 major stock asset classes over rolling 12 month periods you find that the natural divergence then convergence of the past is getting narrower. Stock markets don’t diverge as much as they did in the past yet if you measure the peak to trough divergence you can see there is still plenty of divergence. For example, if you look at the last 12 months of the Russell Large Cap Growth index it has a positive return of about 14% while the Russell Small Cap Value index has one of 3%, while Large Cap International Developed markets are down 5% over the same time frame. This gives you a peak to trough divergence of 14 less minus 5 or 19%. So your blogger friend may be right about markets being more correlated but I would rather focus my attention on having my money and client money invested in Large Car Growth and not in Large Cap Developed. If you add a 4th stock asset class such as Brazil or China they are down about 16% over the same 12 month time frame which is a 30% divergence.
What actually happens is that correlations rise towards 1 when markets are in fear mode such as in February/March 2009 and then start a natural progression back down to a steady state until the next fear cycle. This has been happening since the beginning of time. So if you are asking is there a safe place to hide in the stock market when markets are crashing the answer is no. Every major stock asset index fell over 50% from peak to trough during the Oct 2007 to March 2009 decline. So if you think you are diversifying by owning different stock asset classes you are right——you are not. I repeat—-I see correlations as a fear to greed to fear cycle and not the way most people view it as a new information driven phenomenon. I also see correlations as highly dependent on the time frame you use to measure and would advise you to use only long time frames as measured in years and not minutes or days.
What I espouse about diversification is that everyone must choose to diversify or not as you can read about in A Tale of Diversification. It is the central question or decision you must answer. If you choose to diversify you should also diversify amongst asset classes that don’t have correlations that go to 1 when stock markets are in fear mode. If you pick a an asset allocation of let’s say 60% stocks and 40% bonds and then you re-balance when your allocation to stocks reaches either 66% or 54% you will have satisfactory returns and I suspect out-perform more than 90% of investors on the planet.
I suggest you read my white papers if you choose not to diversify. They will give you insight on ways to concentrate your portfolio in those asset classes that are top performers and avoid those that are laggards. This is just one approach and my preferred approach. There are many others you should examine in your studies. Feel free to keep asking me questions since this is the purpose of this site to promote financial literacy.
Hello again,
Here goes~
Thanks for the detailed explanation! But as I am not so familiar with finance, I have to ask a few questions just to understand the lingo
1. When you talk about the math behind diversification proving that diversification works, what equation/s are you talking about?
2. What IS the Russell Large Cap Growth index and Large Cap Developed, and where can I find this statistic?
3. And what you said about stock market correlation rising to one during fear modes is interesting! Where did you get this data?
4. Finally, Buttonwood says, “Global funds are invested in Brazil and China because investors want a diversified portfolio. But the very act of diversification means that these markets become more tied to the developed world and the rewards of diversification are accordingly reduced.” I think what he means by becoming more tied to the developed world is this: “If retail investors in Iowa want their money back, fund managers have to sell something and that may mean Brazilian or Chinese equities.” Would you disagree, then, with the first quote? Because Buttonwood seems to say that diversification ITSELF is soon doomed to no longer work, and this is not what you’re saying, right? You say that the rewards may be less than in the past, but diversification itself is still sound, right?
Also, you said that cycles of fear correspond to high correlation, but while I can see this for the 2008 crisis, how does this explain the spikes in correlation around 1982, 1988-89, 1992, 1996, 1999, and 2003 (these are rough estimates based on the graph of Buttonwood’s article)?
And just on a personal opinion question, why do you believe diversification will lessen? Wouldn’t the dollar appreciaton against foreign currencies prompt people towards MORE diversification of assets, since foreign assets are held in foreign currencies
Christine,
While cycles of fear—or the herd instinct-are stronger than cycles of greed—also the herd instinct–though not as strong—both cause correlations to rise. Fear is just a stronger emotion than greed when it comes to correlations. When folks panic they sell without thinking and move to safety.
In terms of diversification and why I think it will lessen we must be clear. There is in my opinion a distinct difference between stock asset class diversification for an all stock asset class portfolio vs. diversification of a portfolio that includes other asset classes. When I say diversification will lessen I am talking about the all stock asset class portfolio—I can’t imagine a scenario where we get the divergences in major asset classes into the future that we have seen in the past. However, I do not believe that diversification will lessen when you include other assets into your portfolio mix such as Bonds—US and Foreign, Real Estate–US and Foreign, Energy, Commodities, Currencies and Alternative Investments.
You are correct in asking about foreign currencies if your question is one about diversification. If you have all your assets denominated in a single currency you are betting on that country doing well and I think that is a mistake.
In terms of diversification math—-I leave that up to you. You can start with the original Markowitz paper and work your way up to the French Fama three factor model—circa 1994. Or you can read French Fama first and then see the sources they cite to teach yourself. I like to learn by working backwards.
In terms of Russell—just go to their site and you will see they have past data available.
In terms of correlations rising—-I do my own research on this. It’s important to recognize that correlations are a function of the time frame you use so be careful. Most importantly—-you can’t trade correlation because it can be misleading. You can have 2 assets that are perfectly correlated and one makes 100% while the other makes 20% over the same time frame. I am far more interested from a profit motivated perspective with looking at price divergence over different time frames.
Your final question is really asking will stock asset classes continue to diverge—-the answer is absolutely without a doubt. I don’t know Buttonwood but I can say with certainty that as long as man measures there will be divergence. We are the markets—-they are not us. We give them life with our opinions as we place our bets. As long as we have different opinions we will have divergence. I suggest you read my white paper Will Asset Classes Continue to Diverge and Converge.