Diversification is a very important concept in investment as it is one of the primary tools for reducing risk. It is almost universally accepted as part of proper portfolio management, yet it is misapplied by nearly everyone. This series of articles will discuss some of the most common diversification mistakes made by investors ranging from retail to highly educated and highly seasoned portfolio managers. There is a better way to diversify, and we will demonstrate how to do it.

The Ubiquitous Fallacy

Asset allocation has become so prevalent among investment managers that few even question its validity. In fact, it is a diversification method that is even endorsed by many highly reputable universities. Let us not fall victim to its esteem and instead see it for what it is: an arbitrary constraint. Allow me to elaborate.

The goal of diversification is to spread risk as thinly as possible such that any single risk trigger will have a minimal impact on the portfolio’s performance. The benefit is reduced variance, while the cost is a watered down expected return. Thus, the efficacy of a diversification method can be judged by how well it mitigates risk and how little it waters down expected returns.

How Effective Is Asset Allocation as a Diversification Method?

Every individual asset is exposed to a set of risks, and an asset type’s set of risks is simply the weighted average sum of all of risks of the assets contained within it. Asset allocation strategies involve designating a certain exposure to each asset class with the idea that certain events which would affect a particular asset type may not influence other asset types, thus diversifying the portfolio’s risk.

It sounds great, but let us remove the blindfold. The only difference between a portfolio that uses asset allocation and one that doesn’t is a set of constraints restricting which assets can be bought. Asset allocation divides all investments into arbitrary pockets based on some common theme. It assumes that all assets falling under the same label are necessarily similar. Logic dictates that this is not the case and I can demonstrate this through a hypothetical.

Imagine there are two farmers harvesting eggs. The first has 10 red baskets between which he evenly distributes the eggs while the other has 10 baskets all of different colors and he also distributes the eggs evenly. Furthermore, imagine that each color of basket is considered to be an asset class. Would the farmer with 100% of his eggs in the red asset class have more risk than the farmer with 10% in each asset class? Obviously the answer is no, as the color of basket has no bearing on its structural integrity. One red basket breaking would not necessitate all other red baskets failing. This hypothetical may seem a bit silly, but the actual real life asset allocations are almost this arbitrary.

The number of ways in which portfolio managers divide asset classes is nearly infinite so I cannot exhaustively disprove all of them, but let us examine the absurdity of some prevalent methods.

By Size

Many will suggest various weightings between small-, mid- and large-cap stocks. The only way doing so would increase the diversification of a portfolio would be if each size had correlated risks. Sure, small caps tend to perform better in the long run and have more volatility and large caps tend to be more stable, but that is not evidence of correlated risk. An adverse change to healthcare insurance coverage would hurt healthcare companies dependent on insurance reimbursement regardless of their size. Thus, size diversification alone does not fully diversify a portfolio.

By Sector

If we stick with the adverse change to healthcare insurance as a risk example, wouldn’t restricting the amount of allocation to the healthcare sector create diversification? Well, let’s consider two very small portfolios for simplicity. One invests in a healthcare company and a BDC while the other invests in the same healthcare company and a second healthcare company.

When the adverse insurance change occurs, only one of the healthcare companies was hurt as it was dependent on reimbursement from insurance, while the other obtained over 90% of its funding from Medicare and Medicaid which remained untouched. The BDC, however, happened to be one that invested in upcoming healthcare companies, some of which were highly dependent on insurance reimbursement.

Even though the adverse change was to the healthcare sector, the entirety of the portfolio subject to the asset allocation requirement restricting it to 50% healthcare and 50% BDCs could have been hurt. In contrast the 100% healthcare portfolio was at most 50% afflicted as it diversified by source of revenue stream.

Cost/Benefit Analysis of Asset Allocation Strategies

Some would argue that the examples above are extreme or cherry picked to make a point, and they are. However, the point of going through these examples is to show that asset allocation strategies only generally work and are far from perfect diversification. Thus the benefit is a mild amount of diversification brought about by a heuristic and somewhat arbitrary approach. One could also note that there is a substantial cost to asset allocation strategies.

Suppose the fundamentals are lining up perfectly for a certain sector yet its market prices have not yet risen to meet the new information. An investor may reasonably feel this sector has a higher expected return than other sectors, yet the constraints put in place by his asset allocation strategy prevent commitment of more than 10% to this sector. He must also commit 10% to the sector he believes has the lowest expected return to meet that sector’s constraint. In such a scenario, the use of said asset allocation strategy would substantially reduce the expected returns of the portfolio while only providing heuristic, fundamentally flawed, diversification.

Asset allocation adds another cost: the introduction of unknown risk. Unknown risk is defined as the risk an investor is not aware of. There are more stocks in the market than anyone can feasibly follow. The greater one expands one’s investment universe, the less closely he/she can follow and understand each stock. As many asset allocation strategies forcibly promote a broad spectrum portfolio, it necessarily reduces the depth of understanding. As one puts money into stocks less deeply understood by them, it introduces unknown risk.

A Word About the Prevalence of Asset Allocation

Thus far, we have logically demonstrated asset allocation strategies to provide moderately effective heuristic diversification in exchange for reduced expected returns and the introduction of substantial unknown risk. If these strategies are so flawed, why are they used so ubiquitously among investment professionals?

1. Liability: The use of an asset allocation strategy makes it easier to blame the market. If one invests 100% of a client’s funds into a single issue and it fails, the client would be more likely to sue.
2. Ease of use: Asset allocation makes managing the portfolio easier. Any time a constraint is introduced, it reduces the scope of possible choices. Also, by using stocks that are generally not correlated it removes the necessity of looking at each potential risk individually. Rather than labor in the study of all possible risks and carefully constructing a portfolio that intelligently diversifies them, one can use asset allocation as a fairly reliable educated guess based on the asset class correlations. Some would consider the marginal advantages of the hand-crafted portfolio to be small relative to the massive amount of hard-work it takes to construct and maintain.
3. Marketing: Use of a predefined asset allocation strategy makes it far easier for funds to raise capital. It is very difficult to sell a fund in which the manager will hand-craft the portfolio after its commencement. Investors like to know what sort of investments they will be getting into.

Unfortunately, the three reasons listed above may be sufficient to continue the propagation of asset allocation as a diversification strategy among investment professionals.

There Is a Better Way

At the start of this article I promised to show a better way to achieve diversification. In my opinion, it simultaneously provides superior diversification and reduces expected returns by less than asset allocation. Furthermore, it requires fewer positions which saves on commission costs and substantially reduces unknown risk.

Handcrafted Fundamental Diversification

While I would recommend a slightly broader portfolio, we can demonstrate substantial diversification with a portfolio of only five stocks.

1. American Realty Capital Properties (NASDAQ:ARCP )
2. Northstar Realty Finance (NYSE:NRF )
3. Omega Healthcare (NYSE:OHI )
4. RAIT Financial Trust (NYSE:RAS ), Series A preferred (RAS-A)
5. Weyerhauser (NYSE:WY )

Diversification is not an immunity to risk but rather the asynchrony of it. The portfolio above can be demonstrated to react asynchronously to a plethora of fundamental risks.

Inflation Risk

As a fixed-income investment, RAS-A would be adversely affected by inflation. This is asynchronous as the other four investments would be mostly unharmed or even benefit.

ARCP and OHI have long-term triple net leases, many of which have built in rent escalators based on CPI (consumer pricing index). Consequently, their revenues would go up with inflation so as to produce approximately the same real return. NRF holds equity interest in a wide variety of real estate, which has a tendency to increase in value to reflect inflation. Its real revenue streams may diminish slightly, but its book value would increase, so it could be considered a wash. WY has the ability to instantaneously increase the prices of its lumber products to reflect the market, so its real revenues should remain constant in the face of inflation. As most of its assets are land, expect its book value to rise with inflation as well.

Economic Risk

Northstar is moderately levered and engages in some investments that are susceptible to adverse economic changes. This risk is also asynchronous as the other companies are well positioned to handle a downturn.

ARCP has around a 10-year weighted average remaining lease term with mostly investment grade tenants. Consequently, its locked-in revenue stream would remain strong even in a weak economy. OHI’s focus on skilled nursing facilities makes it arguably economically neutral as healthcare demand is not correlated with the economy. Timber companies like WY have the ability to simply not cut their trees and just let them grow bigger. This would forgo the weaker log prices of a downturn and allow greater harvesting once pricing recovers. Additionally, WY’s international exposure would thrive if the downturn was strictly domestic. RAIT Financial may be hurt a bit by a poor economy, but it would likely not be hurt enough to prevent the dividend payment of the 8.2% yielding RAS-A. Preferreds tend to outperform during recessions.

Clearly this is not exhaustive of the sort of considerations one would have to make to diversify a handcrafted portfolio. In addition to the macroeconomic risks discussed above, handcrafted fundamental diversification requires looking at more specific events. For example, one must consider using geographic diversification to ward off natural disasters. One needs to make sure the portfolio as a whole could handle nearly any scenario even if individual assets will fail. It takes an extreme amount of research and thought, but the superiority over blind asset allocation is immense. By using only stocks one expects to outperform, there is little sacrifice of expected returns. It does not introduce unknown risk and diversifies it fundamentally rather than heuristically.

Conclusion

While there are legitimate reasons to consider asset allocation strategies, the consensus sentiment that they are the ideal means to diversification is a fallacy. One can create superior diversification at a lower cost by looking at the granular risk factors and ensuring asynchrony among a portfolio.

Disclosure: I am long ARCP. WY. NRF. RAS. OHI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: 2nd Market Capital and its affiliated accounts are long WY, OHI, ARCP, NRF, RAS and RAS-A. I am personally long OHI, ARCP, NRF and RAS-A. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.