Diversification or Di-WORSE-ification; A Risk Management Tool or a Drag on Returns?


Michael Santelli, CFA, Managing Director, Portfolio Manager

Diversification is a primary tool in the important process of risk management, which, in our opinion, is an important part of portfolio management. Risk management, at some level, means trading off the possibility of big upside returns for a reduction in the possibility of big downside returns.

Cartoon reprinted with permissions from 361 Capital.

We have the ability to build diversified portfolios for clients that include domestic stocks, international stocks, bonds and alternatives when appropriate. Through the first three quarters of the year, the only major asset class that had generated positive returns was US stocks and, in particular, growth stocks. As the cartoon above suggests, why don’t we just allocate all client assets to the best performing asset class? Of course, if we could, we would. However, markets are uncertain and we are not clairvoyant. Harry Markowitz, one of the fathers of modern finance and 1990 Nobel Prize winner in Economics, called diversification “the only free lunch in finance”.

The theory is that by diversifying into asset classes that are not highly correlated with one another, that is, they move up and down at different times, an investor can either reduce risk without sacrificing expected returns, or increase expected returns without adding risk. As these uncorrelated asset classes generate different returns, an investor has the choice of whether to rebalance or not. Rebalancing trims the winners and adds to the losers in the expectation that there is mean reversion over time. The problem is that this strategy works in the long run. In the short run, there always seems to be one asset class that is significantly outperforming others. In recent years, that outperforming asset class has been domestic large cap growth stocks. Despite the poor performance of international stocks and bonds so far this year, we will continue to encourage investing in diversified portfolios that include those asset classes, but will tailor the exposure to the risk tolerance and needs of each individual client. It is worth noting that history is littered with examples of today’s outperforming asset classes becoming tomorrow’s underperformers.

In terms of defining risk, we believe a good starting place is the likelihood of a permanent impairment of capital. To reduce this form of risk, we do not put all of our eggs in one basket and focus on quality in both the equity and fixed income sides of the portfolio. Where appropriate, we add alternatives for further diversification of return streams. We believe this approach limits the risk of permanent impairment of capital, because quality tends to endure and risks are spread across different asset classes.

If a portfolio has more risk than an investor is comfortable with, there is another risk to consider, the increased likelihood that the investor is unable to hold on for the long haul through the normal ups and downs of the markets. If this is the case, the investor may bail from the portfolio at precisely the wrong time, turning a temporary impairment of capital into a permanent impairment of capital. To mitigate this risk, we tailor portfolios to the personal risk tolerance and return needs of each client. We are not swayed by investment fads nor overly attracted to the current “hot” asset class du jour that can also cool so quickly. We will stay focused on the task at hand; to protect and prudently grow client portfolios to meet their long-term goals, utilizing best practices around portfolio construction that have withstood the test of time.

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