Why diversify—especially in years like this when the S&P 500 is doing so well? The essence of diversification is captured by the proverb: “Do not put all your eggs in one basket.” Insights into diversification were given a theoretical basis by Harry Markowitz (1952), who won the Nobel Prize for his work in 1990. Click here for an interesting visual about diversification Click Here
The first article is a reminder that diversification isn’t broken; it just takes a while to realize the benefits. The second article compares diversification to taking a flu shot; we know it’s good for us even though it may sting a bit. The third article, written shortly after the financial crisis, reminds us that when it comes to diversification, valuation matters. Finally, we look at an article that summarizes recent research that concludes the rich make the same investment errors as everyone else.
Diversification Isn’t Broken, It Just Takes a While. The writer makes a common observation about diversification, “Why bother diversifying at all? It’s just a drag on performance,” as it may seem in years like this with the S& P 500 doing so well. He reminds us of some past history, which is summarized and expanded as follows:
Concentrating your eggs in the S&P 500 basket in 1998 would have been a setup for future disappointment as other asset classes turned. The writer reminds us that diversification works over time and sometimes is not exciting. “It’s the investing equivalent of hitting singles and doubles your whole life… we want to hit homeruns….diversification can look like a mistake at any given moment…a well-designed and diversified portfolio will always have something that’s not doing well, a few things that are average, and hopefully, one or two things that are exciting….if you have something in your portfolio that you’re complaining about, it’s a good sign you’ve built a diversified portfolio.”
Global Diversification May Sting Just a Bit. The writer, the Chief Investment Officer of Russell Investments, addresses some questions his clients are posing at the moment. They ask, “In this rewarding climate, why do we purposefully constrain the potential rewards by designing portfolios that are more diversified? If the table is set for extra portions, why not help ourselves to seconds? How does diversification help when you don’t appear to need it? The investor who looks backward to conclude that he really didn’t need diversification is the same investor who simply wants to always invest in the asset class that will deliver the highest return…the wanting and the doing of such prescient practices are about as far apart as the partisan debate over debt ceilings in Washington.” Instead, the author reminds us that “diversification is the cheapest mechanism for managing portfolio volatility and protects against imprecise inputs.” Said another way, diversification safeguards your money from the over-confidence inherent in concentrated bets that look great in the rearview mirror.
When Diversification Failed. In the immediate aftermath of the financial crisis, Ben Inker of GMO drew some insightful conclusions about the value of diversification. He suggested investors should reassess the virtues of diversification and look beyond static models to more dynamic asset allocation models. He noted the importance of valuation—that most of the money lost in the downturn had simply come from overvalued assets reverting to the mean. He noted that the subject of risk is not a simple concept. Diversification helps to protect against the idiosyncratic risks of a group of stocks, but not the common risks. “While diversifying your portfolio of risk assets will reduce price risk under many circumstances, it does not change the fact that they remain risk assets, and it is unwise to think that the diversification justifies increasing the overall allocation to risk assets. For investors that can take the timing risk, it makes sense to go beyond diversification in risk assets and dynamically allocate their portfolios, both in terms of which risk assets to own, and what the overall allocation to risk assets should be…a superior solution would be to actively avoid the asset classes that have price risk, and let your overall allocation to risk assets be driven by the general return to risk that the markets are offering….layering on an understanding of price risk may help to improve your portfolio significantly. Rather than having a static allocation to each class of risk asset, it makes more sense to keep all of them on the menu, but shift the allocation as valuations, and therefore risk/return trade-offs, shift.”
Rich make same investment errors as rest. “When investing, it often hurts to think of what might be possible if only you started with even more money…the latest exhaustive research shows that the wealthy are prone to almost exactly the same mistakes as everyone else. Indeed, they seem to have handled the crisis of 2008 somewhat worse than the average investor….It turns out the wealthy manage their money in much the same way as everyone else….They are just as keen as their poorer brethren to follow investment fads…their behavior is less different than might be expected.” (Financial Times—Tiered Subscription model)
And in case you missed it, click here to read last week’s blog post which focuses on answering the question, “Are we in a bubble?”
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J. Mark Nickell & Co.
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