Diversification

Long before the creation of modern portfolio theory, complex financial derivatives or alternative investments, Don Quixote’s famed sidekick Sancho Panza wisely observed that “it is the part of a wise man to keep himself today for tomorrow and not to venture all his eggs in one basket.”

Diversification is defined as the balancing of an investment portfolio by dividing funds among securities of different industries or of different classes. The rationale behind this portfolio construction and risk management technique is that a portfolio of differing investments will, on average, produce better risk adjusted returns and less volatility than its individual components.

The Problem and the Solution

Whereas few individuals disagree that diversification is critical to the success of long term investors, there is disagreement about what constitutes a diversified portfolio as well as an overwhelming amount of misinformation regarding the topic. According to our view of the world (one that is not nearly as mainstream as we believe it should be, due to the successful and misleading marketing techniques of the financial services industry) diversification means to fundamentally own everything.

According to the evidence based research of Dimensional Fund Advisors, the institutional asset class fund provider to whom our clients’ investment dollars are allocated, a truly diversified portfolio consists of many thousands of individual securities.

Our client portfolios are made up of a global basket of over 9,000 stocks, all but eliminating company-specific and sector risks that have caused and continue to cause investors so much pain. Look no further than the performance of AIG, GM, global shipping companies, or many of the national, regional, or local bank stocks to illustrate the point that owning concentrated positions in individual companies is dangerous.

What Does it Mean to be Truly Diversified?

According to our view of the world (one that is not nearly as mainstream as we believe it should be, due to the successful and misleading marketing techniques of the financial services industry) diversification means to fundamentally own everything. According to the evidence based research of Dimensional Fund Advisors, the institutional asset class fund provider to whom our clients’ investment dollars are allocated, a truly diversified portfolio consists of many thousands of individual securities.

Our client portfolios are made up of a global basket of over 9,000 stocks, all but eliminating company-specific and sector risks that have caused and continue to cause investors so much pain. Look no further than the performance of AIG, GM, global shipping companies, or many of the national, regional, or local bank stocks to illustrate the point that owning concentrated positions in individual companies is dangerous.

Regardless of our views, misleading information about diversification is rampant. Take for example a recent publication noting that “studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction.” Such statements completely ignore the current realities within the marketplace, whereby investors can purchase low cost, highly diversified index or asset class funds like we use that contain literally thousands of individual securities. Why own a concentrated portfolio of stocks and take on larger amounts of risk when you can own thousands of stocks efficiently with minimal costs?

Another striking example of bad information regarding this subject can be found in the mainstream financial media. On the “Am I Diversified” segment on CNBC’s Mad Money program, investors call in with their top five holdings and query as to the level of diversification within their portfolios. The host often gives investors who own just five stocks a passing grade with regard to the subject, where in reality, no concentrated portfolio could ever be considered diversified. Giving anyone the perception that owning a handful of securities in any way resembles diversification is misinformed and foolish. This type of misinformation is explicitly linked to the lack of investment success that many individuals have experienced over the years.

Why This Matters to You

Diversification (or the lack thereof) has serious implications for portfolio performance and your ultimate success as a long term investor. The difference between a properly and a poorly diversified portfolio could be the deciding factor on whether or not your financial goals are met. Seem like an overstatement?

Consider this: we know that individual investors significantly underperform market rates of return on average. According to Dalbar’s 2009 Quantitative Analysis of Investor Behavior, average mutual fund investors underperformed the S&P 500 (a basket of 500 large U.S. companies) by nearly 6.5% per year for the twenty year period ending 12-31-2008.

Although investors’ behavioral biases often contribute to their lack of investment success (the topic of next month’s newsletter), the severe lack of diversification in many portfolios also plays a key role. After nearly 30 years in the business, we have seen firsthand how grossly under-diversified most investors are and how much that has cost them over the years. Take note that this is rarely the fault of individual investors who trust in their advisors to provide a diversified portfolio.

Most investors believe they are well-diversified, however we know that this is simply not the case. We are continually surprised to see how many portfolios completely lack many of the best performing asset classes such as US small cap value, international small cap value, and emerging markets. Additionally, the few portfolios actually containing these top performers are often under-diversified and own a fraction of the companies available in the asset class.

The difference in compound returns between a well and a poorly diversified portfolio over your investing lifetime makes a huge difference, often to the magnitude of six figures or more depending on your level of savings. We are committed to being agents of change regarding this issue and to delivering the kind of investment experience that you deserve.

Recommended Actions

Given the importance of diversification to your success as a long term investor, we would recommend the following:

1. Review your most recent investment account statement. If you see a list of individual stocks or bonds, or a handful of mutual funds, the chances are you are under-diversified.

Next Steps

We would welcome the opportunity to talk with you about questions you may have or challenges you are facing.

There is no charge for our consultations and we can go into as much detail as you like. Call us at 800.331.7212 (or 707.443.2741).