The Art of Diversification

Nobel Prize winner Harry Markowitz demonstrated one of the most well known and influential economic theories in 1952 under the title "Portfolio Selection."  This well known article, featured in the Journal of Finance, focused on the importance of risk and return in relation to diversification and reduction of excess risk within an investment portfolio.  At a basic level, Markowitz demonstrated that each security has its own deviation from an expected return, statistically recorded as a standard deviation from the mean, namely referred to as risk.  The risk of an overall portfolio should be expected to decrease as the number of securities increase.  Being from Kentucky, the self-proclaimed horse capital of the world, this concept is demonstrated in horse racing all the time.  Gamblers wager significantly on the low-odds horses, while also betting lightly on the "long-shots" just in case there is a freak occurrence of a high odds, high paying finish.  As more horses are added to their bet, the likelihood of winning increases.  Conversely, like investing, adding additional entries decreases the likelihood of loss.

The horse example demonstrates a factor that Markowitz focused significantly on; stating it is not only about picking securities, but it is about choosing the most appropriate allocation of securities.  Different securities bring in two separate fundamental concepts of risk: unsystematic risk and systematic risk.  Unsystematic risk is risk that is specific to individual companies, sectors, or industries and can be mitigated with a well balanced portfolio.  Building a non-correlated portfolio will generally help accomplish this goal.  An example of this might be not having all assets in motor vehicle production companies after a supply chain affect, resulting from the Japanese earthquake.  Systematic risk on the other hand cannot be mitigated by dividing risk among stocks, but rather by adding additional asset classes.  These risks include interest rates, wars, and recessions - most notably the Financial/Housing crisis of 2008.  

Once Markowitz explained the idea of risk - defined as systematic and unsystematic - he introduced a concept known as the "Efficient Frontier" - see Graph 1.  Without getting into minute detail, the efficient frontier line graphically demonstrates the relationship between risk and return.  As an investor seeks higher returns, the investor will also intrinsically take on increased risk.  This return to risk ratio grows quickly at first, with each unit of additional risk eventually bringing less and less opportunity for return.  At a point, the amount of additional risk assumed will bring a minuscule, if any, additional return. 

While some investors (and most investment managers) are familiar with the aforementioned explanation of Modern Portfolio Theory, we meet with families every day who are not fully embracing the definition.  While meeting with new people who may currently manage their own portfolio or who may have an advisor managing their assets on their behalf, it is not uncommon to hear someone say they are "diversified."  What we typically find however is that this definition may include a portfolio holding 5 to 10 stocks that likely all fall within the S&P 500, an unmanaged index of the largest 500 corporations.  Rarely, investors may also hold a combination of additional corporate bonds with a 60/40 ratio - a "goal" of main street portfolio management.

By definition, yes these investors are "diversified" by holding different stock positions and potentially a portion of bonds.  However, when we peer deeper into the holdings, sometimes we find that of those 5 to 10 stocks, they typically fall into only a handful of separate sectors.  It is also not uncommon to see the bonds held within the portfolio to be 100% corporate bonds, sometimes of the same companies that the investor holds equity positions in.  With all of the opportunities to diversify one's portfolio today - stocks (large/mid/small cap and growth/value), preferred stocks, bonds (corporate/mortgaged backed/municipal/high yield/convertible), international equity/bonds (developed/emerging markets), fixed return products, real estate, cash, and commodities - we believe that the definition of diversification as described by Harry Markowitz should encompass a much greater variety of holdings rather than simply corporate stocks and corporate bonds.  

What most investors would call their most frustrating investment experiences, the Financial/Housing Crisis left many investors at one point down a negative 40% - 50% (intraday losses even reached 60% down from the peak).  The problem with most investor's portfolios at this point was that most asset classes were acting very similar - demonstrating a downward trend.  All three major United States' stock markets moved eerily similar to each other, as demonstrated by the Graph 2.

Most sectors, styles, stocks, and mutual funds that were correlated with the United States' stock markets all had a similar downward movement.  Many investors lacked the exposure to assets that were not nearly as dependent upon the United States' stock markets, such as fixed income, commodities, real estate, international assets, and cash.  A strategic investment in these areas allowed some investors to mitigate losses.

After the trough in March, 2008, the three major indices gained back to 20% - 15% from market highs within two years. As depicted in the previous chart, the indices did not all return to near pre-crisis levels in an identical relation.  The crisis has left many investors very leery of the United State's stock markets, causing many to hoard cash, investing in money markets or savings accounts.

One factor that Markowitz did not address in enough detail was the impact of investor emotion.  Graph 3 has been depicted by multiple sources demonstrating how investor's emotions fare during market cycles.  Unfortunately, most investors tend to act upon emotion in the most ineffective manners.  For example, during the tech stock rally at the beginning of 2000, people were refinancing their homes, borrowing from children's college accounts, emptying their savings accounts, etc. to fund whatever the hottest stock was that day.  That rally, albeit significant, came to a screeching halt with most investors missing the peak and unfortunately riding the downturn, potentially losing the gain they had previously acquired.  This is an example of the point of maximum risk.  A second example was in 2008 - 2009 when investors were pulling their investments out of the market after feeling the results of a 40% or 60% loss.  The result of this action was that they missed the upturn shortly after and still remain significantly less than where they would be if they had not made an emotional decision.  This example is of the point of maximum financial opportunity.

With the explosion of a global market, speed of information, and internet/phone capabilities, the world is very different from the days of Harry Markowitz.  Corporations now locate in multiple countries, ship products to hundreds of locations, and may not even have a physical brick and mortar location for customers.  Investors today can choose to invest in a company through common stock, preferred stock, convertible stock, privately traded stock, long-term bonds, intermediate-term bonds, short-term bonds, options contracts, mutual funds, insurance contracts, and a handful of other options.  This being said, diversification now must include a variety of options greater than a diversified holding of common stock and corporate bonds.

An appropriate portfolio allocation is independent for each individual investor based upon several factors.  These factors primarily consist of but are not limited to: age, investable years before retirement, risk, required necessary return, and current/future goals.  Upon determining one's personal needs, it is important to consider two types of investments in one's portfolio - fixed return investments and marketable investments.  As one gets closer to retirement or enters retirement, it may be appropriate to consider a less risky portfolio design.  Those retirees who entered retirement in 2008 and were invested partially in this type of investment likely feel more comfortable currently than those who were fully marketable.  

When creating a diversified, marketable portfolio, the allocation should be fluid with continual reevaluations based upon market conditions.  For simplicity sake, this article demonstrates the statistical difference between a modernized, diversified portfolio versus a diversification of the largest 500 U.S. corporations, otherwise known as the S&P 500.  This study used Vanguard Funds (low cost options) when available and used other exchange traded funds when a Vanguard fund was not available - all are low cost options.  Often, portfolios are weighted with high risk/high return assets as a small overall percentage and low risk/more predictable return assets as a higher percentage.  However, for ease of this article, each asset class was weighted equally at 5.55%.  Below are the funds used for comparison.  Please note, this portfolio entails a variety of asset classes that we typically recommend holding within a portfolio.  It does not however include all asset classes and the allocation/funds used in this paper do not reflect current market conditions, nor is the described allocation a recommendation.  Rather, the allocation described is purely for demonstrational purposes only. 

Both the modernized portfolio and the S&P 500 index were evaluated by several statistical parameters within the assessment of Morningstar's Advisor Workstation.  Most investors are unfamiliar with Modern Portfolio Theory evaluations of Alpha and Beta.  Alpha is the risk-adjusted measure of an expected return on an investment.  In layman's terms, alpha represents the excess or shortage of compensation relative to the expected risk generated by a certain activity.  In an efficient market, assuming the S&P 500 is efficient over the long-term, the alpha coefficient should be zero and portfolios with an Alpha greater than 0 should return more, relative to risk, than the S&P 500.  Beta is a statistical measurement of macro deviations associated with a certain stock or portfolio relative to the market - in this paper the market is the S&P 500.  Assets/Portfolios are compared against the market itself, which has a Beta of 1.0.  If a stock/portfolio's assets vary at a greater rate than the market, the Beta will be greater than 1.0 and vice versa.  Most investors are best served with a Beta of less than 1.0.

The portfolio described previously recorded a three-year Alpha of 2.71, five-year Alpha of 3.67, and ten-year alpha of 5.67 - all more statistically appealing than a diversification of the top 500 U.S. stocks.  The Beta calculation recorded a three-year Beta of 0.87, five-year Beta of 0.85, and ten-year Beta of 0.80 - all more statistically appealing than a diversification of the top 500 U.S. stocks.  

The overall positioning of a portfolio is also important in evaluating two portfolios.  A goal in any portfolio is to achieve the greatest amount of return while taking the least amount of risk.  These risk/return ratios are going to differ depending on investor's goals and emotional responsibility.  The scatterplot below graphically illustrates the risk versus return results of two diversified portfolios - our example (including assets falling outside the S&P 500) and a diversification of the S&P 500 index.  Please note - for statistical analysis, the Portfolio indicates our previously described portfolio and the Bmark is the benchmark, the S&P 500 Index.

As depicted, the portfolio created for this article over the past three, five, and ten year periods has achieved a higher before-tax return, while taking on less risk (as demonstrated by the mean and standard deviation, respectively).  The next two charts illustrate the historical returns in a bar and line chart format, highlighting the portfolio created outperforming the S&P 500 in 25 out of the past 38 quarters.  

With the backdated data above, it is clear that the definition of diversification needs to be broadened to include not only stocks but also asset classes that are not correlated to the market.  The timing of this article makes the argument more powerful, however it can be statistically proven in nearly any market condition.  The optimization of one's portfolio is created by an experienced investment manager selecting the accurate allocation of mutual funds, stocks, bonds, etc.  This article used low cost fund options for illustration purposes only.  In practice, an investment manager would not only want to diversify their assets but also diversify by fund managers.  For example, if one company was bearish on large cap growth and another was bullish on large cap growth, the two funds' holdings would look different.  One would likely outperform the other in the management of the fund, depending on the overall market results.  It is therefore important to diversify both assets and fund managers.  On a similar note, it is important to not always investment in the "hot" area.  Contrarians tend to win in investing, therefore allocating a portion to an area that has historically performed well, although may be underperforming over the recent short-term, is sometimes appropriate.  An example of this is staying in the market in March 2008 when the indices were off nearly 50% from their highs and most analysts were advising people to move their money to more secure holdings.

It is a pleasure to write this article and for any questions related to the data, topic, or theory it would be encouraged to contact Boardman Wealth Planning in Lexington, Kentucky.  Boardman Wealth Planning is a financial planning firm providing personal Chief Financial Officer services for affluent clients. 

Securities offered through Comprehensive Asset Management and Servicing, Inc. ("CAMAS"), 1-800-637-3211 Member FINRA/SIPC.  Advisory services offered through Boardman Wealth Planning Inc. Boardman Wealth Planning Inc., is independent of CAMAS.