Two Key Benefits of Portfolio Diversification

Now that eight years have passed since the S&P 500 bottomed in March of 2009, I thought it would be a good time to revisit portfolio diversification. It’s easy to become complacent toward risk when the stock market keeps generally moving up from year to year. When times are good it is common that the average investor begins to take on more and more risk. In the short-term, markets are completely unpredictable and risk will show up when you least expect it. It has been my experience over the last 20 years while working with high net worth investors that excessive risk taking/lack of diversification is probably one of the greatest common mistakes I see investors making.

One of the golden rules of investing is to diversify your assets, or as you have probably heard, “don’t put all of your eggs in one basket.” Taking on too much risk and not properly diversifying your investments is one of the quickest ways to derail the success of a long-term financial plan. When designing your portfolio, our objective is to create a mix of assets that will provide you with a high enough expected level of return to meet your long-term financial goals while taking the least amount of risk possible to obtain that return. It just so happens the two key benefits of diversification are:

1) increasing your expected return while allowing you to take less risk

2) helping you avoid frequent and large losses

Every investor has a unique personal risk profile. Through the power of diversification we can maximize your possible future return given the specific level of risk you are willing to tolerate. When many investors first start accumulating assets they tend to believe the sole focus of investing is to generate large returns. But to generate large returns, you need to take concentrated risk. Like a coin, there are two sides to risk – the upside and the downside. Many are on a great scavenger hunt looking for the one great investment that will change their financial destiny. Investors that focus solely on the upside of risk (large returns) are many times negatively surprised when the downside of risk shows up. When the markets become extremely volatile, those that have taken excessive risk sometimes panic and liquidate investments at a large loss.

Downside risk and investor behavior

One of the greatest stumbling blocks to many investors’ long-term success is their own emotions. By diversifying, we can control the risk in a portfolio and reduce volatility. If we can manage volatility, an investor can sleep at night and let their portfolio stay on track for the long run.

I have created the chart below to help visually explain why avoiding large losses are so important. The key learning point of the chart is to realize that the larger your loss, the greater your money has to work to rebound back to where you started. As you can see below, a 20% loss requires a 25% gain to grow back to your starting point. However, a 50% loss requires a 100% gain! That’s a difficult hurdle to overcome, which can become impossible if the loss causes an investor to panic and exit out to cash.

 Percentage Loss  Percentage Gain Required to Rebound

 -10%

 11%

 -20%

 25%

 -30%

 43%

 -40%

 67%
-50% 100%

 

I think we all know someone who took too much risk during the tech bubble and/or the housing debt bubble, only to panic and sell out during the large downturns of each respective crash. It has been my experience that the majority of investors become increasingly uncomfortable as their loss approaches 20% or more. Sadly, taking on too much risk is one of the biggest mistakes an investor can make. Your only chance of gaining your principal back is to ride through a downturn and transition back into the positive as the market eventually recovers.

Diversification as a tool to balance your risk and return profile

One of the most efficient ways to simultaneously avoid frequent and large losses and maximize your portfolio return given your level of risk tolerance is to diversify your portfolio. At Wealth Engineering, we use a global diversification strategy that reflects the global economy. We diversify across the two main asset class categories of stocks and bonds, and then we further diversify within each particular sub asset class. Here is a quick review of the many sub asset classes your portfolio may own:

Stocks Bonds
U.S. Large Cap (S&P 500) Short-Term Bonds
U.S. Small Cap Intermediate-Term Bonds
International Large Corporate Bonds
International Small U.S. Treasury Bonds
Emerging Markets International Bonds
Real Estate Investment Trusts (REITs) Inflation Protected Bonds
  Municipal (tax-free) Bonds
Alternatives High Yield Bonds
Commodities, Gold and Energy

 

We further diversify the above sub asset classes on the Stock side by equity style and size of companies. Overall, we favor a tilt toward the “value” style and “smaller” size of companies within stock funds. Much of the academic research we follow documents a compelling long-term outperformance by those stock funds with a slight investment tilt toward smaller companies (more aggressive) and the value style of companies (instead of growth). Think of the value style as investing in companies that based on certain metrics (such as price to book), indicate that certain stocks are underpriced relative to their intrinsic value.

Combining non-correlated assets

As you can see in the above chart, we invest in approximately 15 different asset classes. The purpose of so many asset classes is that we are seeking to find asset classes that are “non-correlated.” This is a fancy way of saying we want investments that do not all move in the same direction at the same time. An economist named Harry Markowitz brought forth the idea of combining non-correlated assets via his research at the University of Chicago. He won a Nobel Prize for his development of “Modern Portfolio Theory (MPT).” We find tremendous value in MPT and it is at the cornerstone of how we build portfolios today.

Through the science of MPT we can create a globally diversified portfolio that balances risk and return. Some of the asset classes we use are high octane, high risk and volatile (for example, small cap value and emerging markets). But by combining a wide mix of risky and volatile assets with very conservative and less-volatile assets (for example, high quality bonds), we can smooth out the risk and return profile of a portfolio and maximize your possible return relative to your ability to handle risk.

Asset class charts

If you click on this hotlink it will take you to an asset class chart from JP Morgan – Asset Classes – JP Morgan – 12-31-2016. The chart illustrates annual performance for many of the asset classes we use. Those in the top rows are the highest annual performers and those in the bottom rows the lowest annual performers. This is a great visual replication of the benefits of diversification. The key takeaways from this chart are:

  1. Asset class performance is completely random. Last year’s winners are many times next year’s losers.
  2. The more volatile stock asset classes, such as Emerging Markets, consistently swing from having high double digit positive performance to high double digit negative performance.
  3. JP Morgan outlined a mock “asset allocation” mix on the chart (the solid line connecting the allocation mix dots from year to year). You can see the benefit of the diversification mix as the allocation portfolio tends to consistently perform in the middle of each respective chart, thus avoiding frequent and large losses!

If diversification is so great, what are the downsides?

There are two issues around diversification that I would like to point out. I wouldn’t necessarily call them downsides, but they will cause an investor to take notice occasionally depending on market conditions.

  1. A diversified portfolio will never be at the top of the “asset class chart” when ranked by performance. This doesn’t mean you can’t have strong overall performance from your globally diversified portfolio. It only means that your portfolio is by nature a mix of the performance of every asset class you are invested in. Thus, mathematically if you average a mix of high performance asset classes and low performance assets classes, the average (your portfolio), is likely to fall somewhere in the middle. But keep in mind, our goal by diversifying is to create a portfolio with more consistent performance, thereby providing you with the highest probability of meeting your long-term financial goals. For a baseball comparison, when pursuing investment returns, we are seeking “singles” and not “home runs.”
  2. It has been my experience that investors can become restless when they see the S&P 500 outperform their globally diversified portfolio. Our media loves to focus on the performance of the S&P 500. In 2016 the S&P 500 was the third highest performing asset class, while international stocks were one of the lowest performing. Thus, a globally diversified portfolio did not experience anywhere near the same level of performance of the S&P 500. This happens occasionally, but it is my experience that the home country index out performance is usually short-term. The S&P 500 is only one of many assets classes we invest in. It’s also important to know the S&P 500 is 100% in stock, while your portfolio is a combination of stocks and bonds. Although four out of the last five years have been favorable to the S&P 500, it is a great reminder that this media darling also lost 55% during the 2008/2009 housing bubble crash and 43% during the tech bubble collapse in 2000/2002.

Rebalancing your portfolio

When we first start working together, I design a global strategic allocation for your unique portfolio. Each quarter I refer back to that allocation when rebalancing your portfolio to make sure you are still on target for the long run. Some of my clients are in the “accumulation phase” and adding contributions on a regular basis, while many of my clients are retired and in the “distribution phase.” For those in the distribution phase, this means a monthly or quarterly withdrawal from one or more of your investment accounts. By following a disciplined quarterly rebalancing strategy, it ensures that I am constantly maintaining your global diversification posture, while simultaneously maximizing the balance of potential risk and return, regardless of whether you are adding or withdrawing from your portfolio on a systematic basis.

Conclusion

Hopefully all of the above information has given you some additional insight as to why we believe so strongly in global diversification and our disciplined portfolio management process. As we move forward, know that we will continue to pursue additional asset class opportunities if we have a strong conviction it will help us further balance risk and return in your portfolio, minimize frequent and large losses, and most importantly, help us guide you to your long-term financial goals.

About The Author

Dave Fernandez, CFP® is a native of Arizona and has over 20 years of experience in the financial services industry. He started his financial services career in 1995. As a NAPFA Registered Financial Advisor, Dave owns a fee only financial planning and wealth management firm, in Scottsdale, Arizona called “Wealth Engineering, LLC.”