Diversification Means Always Having To Say You’re Sorry
From: brianportnoy.tumblr.com
As much as any topic in finance, cargo ships of ink have been spilled on the topic of diversification. It is unquestionably the anchor to designing an effective portfolio of investments. Though first formally articulated in Harry Markowitz’s seminal 1952 paper on Modern Portfolio Theory (MPT), the idea is commonsense to all of us: Don’t put all of your eggs in one basket.
Because we don’t know what’s going to outperform, we spread our bets across a variety of investments. The trick, if it is one, as shown mathematically in MPT, is that we need to consider how the price of each investment varies in relation to the others. Assuming they don’t move in lock step with each other, there is inherent benefit in owning lower-correlated investments. Doing so allows us to hold a more “efficient” portfolio, meaning either: (1) for the same level of risk, we can earn higher returns or (2) we can achieve a similar return level but at reduced volatility.
Sounds good! But of course there’s a catch — and one that few have actually commented on. Being truly diversified means that there almost always will be a part of your portfolio that is sucking wind. (Big note: if every piece of your portfolio is working really well, it means one of two things: you’re incredibly lucky or you are not actually diversified. I would assume the latter.)
But what’s the big deal about that? Indeed, owning underperformers is built in to the definition. While statistically true, there is an unspoken behavioral component to this experience: We hate owning losers. And we fixate on the negative, drumming up feelings of regret and “if only” I (or my adviser) had tilted more toward fill-in-the-blank.
Examine, for example, one of the many “periodic tables” of asset class and key index returns. I like the one from Callan, but there are many others. And now look only at the bottom line of boxes to see the worst of every year. It reads as such:
2014: -4.90% (MSCI EAFE)
2013: -2.27% (MSCI Emerging Markets)
2012: 4.21% (Barclays Agg)
2011: -18.17% (MSCI Emerging Markets)
2010: 6.54% (Barclays Agg)
2009: 5.93 (Barclays Agg)
2008: -53.18% (MSCI Emerging Markets)
2007: -9.78% (Russell 2000 Value)
And so forth… And then another quick take on the data: Let’s look at the difference in the top performing investment class versus the bottom. Starting from 2014 back to 2007, the gap was: 19.79%, 45.54%, 14.42%, 26.01%, 22.55%, 73.09%, 58.42%, and 49.56%. In Callan’s table, the numbers are comparable going back to 1995. In fact, the 14% difference in 2012 is by far the smallest.
Two things are clear. One, a diversified portfolio will often have outright losers in it. Two, the gap between the top dog and the mutt is often very wide. The opportunity to feel regret is frequent. Alas, diversification usually doesn’t feel very good.
Last year stands as a good example of this discomfort. Take the following balanced portfolio allocation: S&P 500 (25%), Russell 2000 (10%), MSCI EAFE (15%), MSCI Emerging Markets (5%), Barclays Aggregate (25%), CS/Tremont Equity Market Neutral Index (5%), Bloomberg Commodity Index (5%), NAREIT Equity REIT Index (5%), and cash (5%). In sum, 55% equities, 30% bonds, and 15% alternatives (broadly defined).
