March 1, 2016
Many investors know diversification to be the only “free lunch” in finance. The analogy most used for understanding the concept of diversification is to not put all your eggs in one basket, meaning that you shouldn’t risk all your prospects on the success of one venture. Taken in the context of investing, you can usually get a similar return to investing in a single company by simply investing in a bunch of similar companies (without taking on the risk that single company could fail and drag your portfolio down). By diversifying your holdings into a bunch of similar companies, you’re reducing individual company risk; why only hold shares of Apple, Google, or Microsoft stock for your equity exposure when you can hold an index fund to represent the entire tech sector? And if you’re concerned specifically about sector risk and want to lower the chance of any one sector dragging down your portfolio returns, you could further diversify across sectors by investing in the S&P 500. The final piece to diversifying is the generally accepted view of diversifying across asset classes, such as adding bonds as a complement to your stock portion of your portfolio, because bonds tend to have a slightly negative correlation to stocks – bonds have historically tended to do well when equities struggled. Satisfied that they are diversified ‘enough’, many investors stop here after diversifying individual company risk, sector risk, and asset class risk.
A simple 60/40 split between stocks and bonds may be better than just holding AAPL, but, taking diversification a few steps further, there are many institutional investors who have long recognized the benefits of further diversifying geographically and across asset classes (aside from simply holding US stocks and bonds). Other asset classes that are often included in a globally diverse portfolio include international developed equities, emerging market equities, commodities, REITS, MLPs, TIPS, and precious metals. Meb Faber does a great job of talking about the many variations of buy and hold global portfolios in his book Global Asset Allocation; he makes it clear to see how the other variations of allocations that were more diverse than a 60/40 portfolio had higher risk-adjusted returns (Sharpe ratios), due to either higher returns, lower risk, or both.
There are two additional ways to potentially further diversify portfolios: diversification across factors and diversification across strategies. It’s definitely been a trend over recent years for fund companies to roll out new “smart beta” ETFs and “alternative investment” products. As with any other investment, proper due diligence is in order to determine whether the strategy can actually do what the fund company claims, and whether it makes sense within your allocation. Research Affiliates is a great source of information for making the case to add “smart beta” (also sometimes referenced “factor-driven”) investments which diversify across factors that have historically added favorable risk/return characteristics, such as value, momentum, and low volatility. Unlike “smart beta”, which looks to improve beta exposures that can often be achieved through investing in a cheap index fund, “alternative investments” (or “liquid alts” to reference investments in a ’40 Act mutual fund wrapper) often refers to more niche strategies that are sometimes more complicated, more expensive, and more reliant on a particular manager’s investment expertise. With respect to the recent popularity in so called “liquid alts” mutual funds coming to market, there are some investments whose benefits are more heavily documented (i.e. trend following managed futures) and other investments that deserve a more thorough dive into whether the strategy makes sense on its own and as a compliment within your allocation (i.e. countertrend managed futures, closed end fund arbitrage, merger arbitrage, event driven arbitrage, convertible arbitrage, volatility arbitrage, long/short equity, long/short credit, etc.). Given that these strategies are quite complex and deserve such thorough consideration, I intend to go into more detail about these individual strategies in future posts.
To wrap up this broad discussion of diversification, here are some final thoughts. I don’t think you should go out and buy more individual stocks, mutual funds, or ETFs just for the sake of diversification; however, I am suggesting that you take a thoughtful approach to determining which investments belong in your allocation based on your goals, your level of investment knowledge, your risk tolerance, your views on market efficiency, and your ability to implement a strategy consistently over the long-run. As a couple general rules that I use, I will decide to add an investment to my portfolio as long as I expect it to have positive returns over a full market cycle, and also that I expect it to be uncorrelated to the other investments already in the portfolio. If an investment has unique primary drivers of performance that are uncommon in other investments, it will fundamentally be less correlated to the other investments and, hopefully, zig when the other investments zag. For the most part, my ongoing investment research involves monitoring current investment decisions and broadly searching/learning about new ideas and investments that could make sense as a complement or replacement for what I currently own. I realize that I’ll never find the holy grail of two investments that both have positive returns and a perfectly negative correlation, but I suppose I can settle on the next best thing — ultra-diversified, high Sharpe portfolios.