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Investment Portfolio Diversification


In the investment world, “Diversification is King” is a mantra almost as popular as “Buy Low, Sell High,” and, for some, it seems almost as difficult to follow. Time and again, we come across portfolios of well-intentioned investors who have fallen short of proper execution in this regard. Unfortunately, the oversight can yield adverse consequences to account balances, often discovered only after the worst of the damage is done.

What follows are what I consider the ground rules for adequate diversification. To be clear, this article is in no way a blanket recommendation, but it may give readers a foundation for reviewing their own allocations and evaluating potential areas for improvement.

We will start with what I call the “pyramid of diversification.” In my pyramid, we start with the least amount of diversification at the top, and work down to a nice solid base of reasonable diversification.

SINGLE COMPANY STOCK

We encounter this scenario most often when people have enjoyed a long, successful career with a thriving company, accumulating a tremendous amount of employer stock through incentives, options, and availability through retirement plans like a 401(k). Those fortunate enough to work for a business whose equity has performed relatively well over the years may develop a “go with what you know” mindset, trusting the employer’s ability to maintain its vitality throughout their retirement years.

Though a company may be doing well today, the longevity of this scenario is by no means guaranteed, and its future is not something any individual can control. History is littered with the corpses of formerly great businesses that have met a swift demise through corruption, regulatory changes, or failure to adapt to an evolving marketplace, among other calamities. If a company goes under, and all your eggs are in that entity’s basket, your retirement will go down with the ship.

Since you can’t control what a corporation will or won’t do in the future, or how those actions may affect your portfolio, you may decide to hedge your bets by sliding down my pyramid to the next level of diversification.

SINGLE INDUSTRY STOCK

Let’s say you’re an executive for a home-improvement store, for example. They have taken care of you for many years, you know the industry well, and you know the business well. But you also recognize there are some other big players in that arena and the competition is really heating up. To guard against the possibility that your corporation may wind up on the short end of the market-share stick, you decide to purchase additional shares of stock from other companies in the same industry; after all, it’s what you know, right?

But what happens if we experience an event like, say, a real estate collapse (imagine that), which triggers a decline in stock prices for all corporations that service housing and construction businesses? Though your financial destiny no longer hangs on the performance of one company, if a whole industry tanks, you’re still in trouble.

SINGLE “STYLE” POSITIONS

Many years ago, the term “style” was made popular by the research firm, Morningstar®, when it introduced nine different classes of equity positions that, together, encompassed all the available domestic investment options for stocks and mutual funds. Those are: Large-cap value, large-cap blend, and large-cap growth, followed by the same distinctions for mid and small-sized companies. Though less ubiquitous today, these style delineations are still a handy reference for investors who want to evaluate the range of characteristics for all the positions in their portfolio, and would be immensely beneficial if more people would pay attention to the ideas behind investment styles.

Instead, what we find most often are accounts filled with a broad assortment of stocks, mutual funds, and/or exchange traded funds, that may appear well-diversified, but when analyzed, we discover a tremendous degree of style-overlap. For example, a client may have a dozen different mutual funds in their account with individual fund names that may make them sound drastically different from the others. However, a few clicks of mouse might reveal that all are isolated to just one or two style categories.

Why might this be a problem?

As time goes by, different segments of the corporate marketplace will perform differently as we progress through the phases of the economic cycle. That is, some will always be doing better than others, and diversifying across multiple styles will help to smooth out the emotion-inducing peaks and valleys that often lead to poorly-timed investment decisions. To give you an idea of just how much the range of returns for each style can vary over time, consider the following table of annualized performance for large, mid, and small-cap value positions from 1930 to 2013 (with the S&P 500 index thrown in for reference).

S&P 500 Index                          9.7%
Large-Cap Value                     11.2%
Mid-Cap Value                         12.7%
Small-Cap Value                     14.4% 

Includes reinvestment of dividends. Source:  Dimensional Fund Advisors

That may not look like a huge variance until we put some math to it:  An investment of $10,000 into each category in 1930 would turn into a range difference of $685 million dollars by 2013. Of course, not many will enjoy an investment horizon of 83 years, but you get the idea– the more time you’ve got, the bigger the impact even a few percent of additional annual growth will make.

My point is, you don’t want to be stuck in what may turn out to be the lowest performing style, as do-overs are not a luxury we’re afforded in this game. The better option is to shoot for a level of diversification that will yield something near the average of all styles, which, in the example above, would still generate $100 million more growth than a portfolio limited to the S&P 500 Index companies alone.

SINGLE ASSET CLASS

There is just one more contingency we need to prepare for as we approach the base of our diversification pyramid: It is called “systemic” market risk. As the name implies, this threat manifests when events occur that cause an entire asset class to experience a sweeping decline in value. The crash of 2008 is one excellent example. What started as a crisis triggered by hyper-inflated real estate values quickly spread into the financial sectors and ultimately throughout broader stock market, bringing (nearly) the entire “system” down with it.

As many experienced first-hand, virtually no equity-based investment was immune to the carnage – regardless of how well you may have been diversified across companies, industries or styles. In this case, the only thing that could have softened the blow was the foresight to diversify your portfolio across varying asset classes.

As the economy cratered, investments in things like precious metals, bonds, and some currencies actually moved in the opposite direction of the U.S. stock market. This “inverse-correlation” phenomenon, when properly implemented, can be of great benefit in mitigating severe portfolio losses, should we be faced with the threat of another deep correction among broader equities markets.

A Word of Warning:

I’d be remiss to not mention one significant caveat to everything described above, as we are currently experiencing a paradigm shift that may very well rewrite the rules of prudent investing. For the first time in my career, and perhaps ever, we have entered an environment where nearly everything has percolated up into overvaluation (or, dare I say, “bubble”) territory.

The levers which have historically existed between asset classes, moving them in relatively predictable trajectories with or against each other, have become very difficult to discern. This has frustrated countless money managers, as most of the traditional, time-tested maneuvers have proven somewhat, if not entirely, ineffective at managing the daily curveballs the market throws across our collective plate.

In light of this, it is conceivable that we may be staring down the barrel of a scenario where no amount of diversification will be able to insulate investors from the developing vortex from which little will escape when it finally touches down in, what could be, a global economic crisis.

If it turns out this is what we’ve got in store, there is just one more element which may prove a useful addition to our diversification pyramid. Though it is often overlooked, continuing to do so may be at the investor’s peril. I’m talking about cold, hard cash.

In an era where uncertainty abounds and any degree of predictability has gone out the window, there is absolutely nothing wrong with sitting on the sidelines to wait for the dust to settle. There is, of course, a conflict of interest in the financial industry when it comes to cash, as it’s very difficult for corporations to make money when investors aren’t “in the game.” But if being in the game means exposing your savings to unnecessary risks in a tenuous market… well… you’ve been warned.

Regardless of where things go from here, now is the time to take a good look at your current portfolio with your financial advisor. Analyze your diversification, make sure you understand the potential impact of any market scenario – not just the one you’re hoping for, and make sure you’re comfortable with how that may play out. If you don’t feel great about what you discover, make the changes necessary to get you into a zone of reasonable comfort.

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