July 2004
Diversification is an investment principal that is very familiar to the average investor but, like any good idea, if taken to an extreme it can defeat its own purpose. Over our careers, we've seen investment portfolios that have lots of holdings but beneath the surface aren't really diversified much at all. We've also reviewed portfolios that have achieved textbook diversification but are unquestionably destined for mediocrity. Over the past few years the trend has been to over-diversify as consultants and financial planners try to spread their clients' money into all corners of the globe. Of course, this is mostly done with little regard for current prices - but diversification is diversification, right? Not necessarily. We are strong believers in diversification with a strategy that ultimately strives to reduce risk without eliminating the opportunity of superior returns.
More Diversification Is Not Necessarily Better
Most people agree with the old adage that says "don't put all your eggs in one basket" but over the years the number of "baskets" in the investment arena that are considered adequate for proper diversification has grown significantly. Ten years ago it wasn't at all unusual to see a large pension plan managed by only a handful of investment managers. Today that same pension plan might use ten or more managers that are pigeonholed by consultants into investing in only particular slices of the markets. The thinking behind this is for the pension plan portfolio to cover all the bases by maintaining some exposure to all of the major areas of the global financial markets - no matter what. As the consultant and the board of directors make the big asset allocation call, the investment managers tend to operate in a vacuum. At this institutional level, we honestly can't come up with a better solution politically - so we probably shouldn't criticize. But for individuals, we think there is a much better approach.
This trend towards slicing and dicing the diversification process into multitudes of asset classes really took off in the last half of the 1990's and it has forever changed the structure of the investment management industry. For example, prior to the mid-1990's most investment managers were not put into investment style boxes, like small-cap or large-cap managers. They only thought of themselves as value or growth managers and they looked for investment opportunities of all sizes and shapes.
Things changed in the 1990's when the consulting industry was successful in convincing their large institutional clients (the pension plans and foundations) that each market-cap sector of the market had its own unique investment attributes and that their long-term investment returns would improve if they found a way to get exposure to each sector regardless of price or value. (And, of course, they had their statistical models to prove it.) Once the convincing was done, it didn't take too long for business-minded investment managers to squeeze themselves into the myriad of style boxes that were required by the consultants.
As is often the case, what first happens at the institutional level is invariably copied by individuals and now large investment clients are hiring twice as many investment managers as they did 10 years ago and smaller clients have followed suit by using many more mutual funds than they truly need. The cost is real and the result is confusion.
This more complex diversification strategy has been a great benefit to the consulting and brokerage industries. But it isn't clear whether the clients have experienced better returns to go along with the higher management fees and transaction costs. What we do know is that with the larger variety of asset classes represented in portfolios, investors should come to expect lower volatility but also lower returns in the years to come. This relationship is especially true when the portfolios are locked into a fixed asset allocation regardless of current prices.
Hodgepodge Portfolios Can Be Hazardous To Your Wealth
On the flip side, while more and more portfolios are succumbing to over-diversification, we see investment accounts that aren't diversified nearly enough. As professional investment managers, we are commonly asked to review investment portfolios for prospective clients to give an opinion as to its structure (asset allocation) and to the appropriateness of the individual securities. Sometimes it only takes a glance to see if a portfolio has a coherent diversification strategy or if it is just a hodgepodge of stocks, bonds and mutual funds that were accumulated somewhat emotionally. Many of these people are a bit surprised when we discuss the inherent risks within their portfolios because they mistakenly believed that proper diversification was achieved by simply owing a particular number of securities. In other words, a "diversified portfolio" isn't seven bank stocks, six electric utilities, four real estate investment trusts, three media conglomerates and five bonds issued by two different car manufacturers based in Detroit. It may look like diversification but it certainly won't act like it when specific economic events happen.
Another concern is how an investor's personal bias can influence how a portfolio is invested. Some people tend to favor stocks with dividends while others have an affinity for certain economic sectors like financials, energy, or healthcare. It is also not unusual for us to see portfolios concentrated with large holdings of a few stocks that have been held for many years. Naturally, this is often because of a common aversion among investors to paying capital gain taxes. Unfortunately, we have seen too many examples of people who failed to manage the risks in their portfolios only to see the majority of their retirement savings disappear.
Strategic Diversification in Action
At Front Street, we utilize a strategic diversification approach to portfolio management that tries to adequately diversify the portfolio against the specific risk of an individual company falling into bad times or being involved in fraudulent activities without giving up the chance for superior returns. Of course, first in our line of defenses against fraud or bad times is to rely on our own research. Only after that do we look to diversification for protection. We always attempt to have exposure in as many areas of the financial markets as possible as long as we feel they are attractive from a value perspective. But, without a doubt, we don't want our 30th best investment idea to be that much worse that our 20th best idea. We know that chasing stocks with little regard for value and a large regard for diversification is as sure a recipe for loss as it gets. Jason and I followed a value-driven approach in 1999 and 2000 at our respective firms and it helped save our clients from the tremendous losses suffered by so many when the technology stock bubble burst. We would much rather invest in money market funds or short-term bonds and wait for a better time to invest than to force money to work.
John W. Gudritz, CFA
john@frontstreet.com