Some topics are timeless and need to be revisited. Diversification as a tool in risk management is one of those. We wrote about this topic in a late 2018 article (titled Diversification or Di-WORSE-ification; A Risk Management Tool or a Drag on Returns?), and will expand on the topic here.
2021 was a great year for the S&P 500, which was up about 28%. So why diversify? After all, U.S. large cap stocks have been the best performer for most of the last ten years, not just 2021. Simply put, it doesn’t always work that way. Times change and what worked last year may not work this year. I would liken the S&P 500 to a Formula One race car. When the road is straight and dry, you are in great shape. However, add some curves and some rain and snow, and you would wish for an all-wheel drive vehicle for those conditions. Ensuring that other vehicle is already in your garage before the snowstorm hits is not unlike building diversified portfolios and managing risk because the future is uncertain.
While on the topic of diversification, let’s take a step back and take a stab at defining risk. Howard Marks of OakTree Capital, one of the leading experts on risk, puts it very succinctly. Rather than defining risk as volatility, he says that “Risk is – first and foremost – the likelihood of losing money.” In a world of uncertainty, how do we manage this definition of risk? An important start would be to first identify potential landmines in security selection and aim to limit or avoid them. Here are four to give extra consideration to:
- Companies with the potential for financial distress due to overleveraged balance sheets. The financial landscape is littered with examples: Enron, WorldCom, Lehman Brothers, and other large banks in the 2008 Financial Crisis, etc.
- Buying companies with obsolete business models. These are easy to see in hindsight, though more difficult to identify in the heat of battle.
- Buying companies that are wildly overvalued. Again, these are much easier to identify with the benefit of hindsight.
- Forced selling at the wrong time.
The first three of these can be evaluated with a disciplined research effort that focuses on financial durability and reasonable valuations. Number four above can be mitigated with an appropriate asset allocation (again, diversification) and a knowledge of each individual client’s ability and willingness to take risk in addition to their overall liquidity needs from the portfolio.
By building diversified portfolios akin to an all-wheel drive vehicle, we are more likely to prudently grow client portfolios so they can meet their long-term goals no matter what the future throws our way.