Never Look At Diversification The Same Way Again

by Richard Rosso, MS, CFP, CIMA, Clarity Financial

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“If you have large cap, mid-cap, and small-cap, and the market declines, you are going to have less cap.” – Martin Truax

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The financial services sales forces as mass storytellers, have morphed once noble, efficient constructs into treacherous fairytales.

Tenured financial concepts which define the core of advice in the brokerage industry go relatively unchallenged. Investors, due to lack of experience about such matters, have a difficult time challenging the status quo or ask the right questions.

The easiest way to convince investors to “stick with an asset allocation or investment plan” is to use the past as a pacifier, regardless of current market cycle. In other words, if it’s broken there’s no need to adjust the guidance. The industry just needs to isolate and showcase a cycle when the old confines worked, push that specific period of time into the present and extrapolate the positive, perpetually into the future.

I believe nothing changes in practice on the frontlines, as the priority is selling products. Brokerage firm margins are embattled by profit-draining effects of lower-for-longer interest rates. I don’t blame the mouthpieces as much as I do the senior management and compliance departments that channel, reward or benefit from the behavior.

There are several Holy Grail concepts that are rarely revisited except by academics and a select few in the private sector and for their work, I’m grateful. From experience I’ve experienced how somewhere between academia and implementation in the field, updates or improvements to dogmatic strategies` get lost or ignored, especially when they conflict with the short-term focus on shareholder and analyst expectations.

The insidious or naïve (take your pick) roads most selected are designed to mollify fears and at the same time, leave investor wealth exposed unnecessarily to danger.

An egregious stretch of the truth emboldens the heavily-protected sanctuary of diversification.

It’s a word that makes investors feel good.

It rolls sweet off the tongue. It represents warmth of a blanket fresh out of the dryer, the scent of fresh-baked cinnamon rolls.

However, don’t be duped. Today, diversification as pitched by your broker, is a wolf dressed as Red Riding Hood. Many financial professionals have fooled themselves regarding its effectiveness. At least the way it’s defined, currently.

You must understand what diversification is and most crucial, what it isn’t. Certainly, it’s not the panacea it’s communicated to be.

The outdated definition of diversification requires a tune up. There’s no ‘free lunch,’ here, although I continue to hear and read this dangerous adage in the media.

The word gets thrown around like a remedy for everything which ails a portfolio. It’s the industry’s ‘catch all’ that can lull investors into complacency, inaction.

So, who buys into this free lunch theory, again?

After all, what is free on Wall Street? Investors who let their guard down, buy in to the myth of free lunches on Wall Street, ostensibly find their money on the menu.

Due to unprecedented central bank intervention, there exists extreme distortion in stock and bond prices. Interest rates ‘lower for longer’ and in several cases, negative, have created a frenzied reach for yield in dividend stocks. Global risk-averse investors have purchased bonds with a voracious appetite.

A way to effectively manage risk has morphed into two disparate perceptions. The investor’s definition of diversification and that of the industry has parted, leaving an asset allocation plan increasingly vulnerable.

Today, the practice of diversification is Pablum. Watered down. Reduced to a dangerous buzzword.

First, what is the staid, mainstream definition of diversification?

According to Investopedia – An internet reference guide on money and investments:

• Diversification strives to smooth out unsystematic risk events in a portfolio so the positive performance of some investments neutralizes the negative performance of others. Therefore, the benefits of diversification hold only if the securities in the portfolio are not perfectly correlated.
• Diversification benefits can be gained by investing in foreign securities because they tend to be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan’s economy in the same way; therefore, having Japanese investments gives an investor a small cushion of protection against losses due to an American economic downturn.

Now let’s break down the lunch and examine how free it is.

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Unsystematic risk – This is the risk the industry seeks to help you manage. It’s the risks related to failure of a specific business or underperformance of an industry.

To wit:

• This is a company- or industry-specific hazard that is inherent in each investment. Unsystematic risk, also known as “non-systematic risk,” “specific risk,” “diversifiable risk” or “residual risk,” can be reduced through diversification.
• So, by owning stocks in different companies and in different industries, as well as by owning other types of securities such as Treasuries and municipal securities, investors will be less affected by an event or decision that has a strong impact on one company, industry or investment type.

So, think of it this way: A ‘diversified’ portfolio represents a blend of investments – stocks, bonds for example, that are designed to generate returns with less overall business risk.

While this information is absolutely valid, the financial industry encourages you to think of diversification as risk management, which it isn’t.

Here’s what you need to remember:

Ketchup (consumer staples) and oil (consumer cyclicals) all run down-hill, in the same direction in corrections or bear markets. 

Sure, ketchup may run behind, roll slower, but the direction is the one direction that destroys wealth – SOUTH.

Large, small, international stocks. Regardless of the risk within different industries, stocks move together (they connect in down markets).

Consider:

What are the odds of one or two companies in a balanced portfolio to go bust or face an industry-specific hazard at the same time?

What’s the greater risk to you? One company going out of business or underperforming or your entire stock portfolio suffers losses great enough to change your life, alter your financial plan.

You already know the answer.

Diversification is not risk management, it’s risk reduction.

• When your broker preaches diversification as a risk management technique, what does he or she mean?
• It’s not risk management the pros believe in, but risk dilution.
• There’s a difference. The misunderstanding can be painful.

To you, as an investor, diversification is believed to be risk management where portfolio losses are controlled or minimized. Think of risk management as a technique to reduce portfolio losses through down or bear cycles and the establishment of price-sell or rebalancing targets to maintain portfolio allocations. Consider risk dilution as method to spread or combine different investments of various risk to minimize volatility.

Even the best financial professionals only consider half the equation.

Beware the lamb (risk management) in wolf’s clothing (risk dilution).

The goal of risk dilution is to “cover all bases.” It employs vehicles, usually mutual funds, to cover every asset class so business risk can be managed. The root of the process is to spread your dollars and risk widely across and within asset classes like stocks and bonds to reduce company-specific risk.

There’s a false sense of comfort in covering your bases. Diversification in its present form is not effective reduce the risk you care about as an individual investor – risk of loss.

Today, risk dilution has become a substitute for risk management, but it should be a compliment to it.

Risk dilution is a reduction of volatility or how a portfolio moves up or down in relation to the overall market.

Risk dilution works best during rising, or up markets as since most investments move together, especially stocks. Think about betting on every horse in a race.

• In other words, a rising tide, raises all boats.

So, why is risk reduction but not risk management, the prevailing sentiment?

Sales Goals: Most financial pros are saddled with aggressive sales goals. Risk dilution is a set and forget strategy. Ongoing risk management is time consuming and takes time away from the selling process.

Diversification can be stronger than it is right now. Unfortunately, the financial industry as a whole, has watered it down and widened it so much, it’s become absolutely ineffective as a safeguard against losses. One reason is the sales targets that forces financial representatives to spend less time with client portfolios.

Compliance Departments: A targeted diversification strategy places accountability on the advisor and poses risk to the firm. A wider approach makes it easier to vector responsibility to broad market ‘random walks’ so if a global crisis occurs and most assets move down together, an advisor and the compliance department, can “blame” everything outside their control.

• “Hey it’s not our fault, it’s the market!”

Convenient excuse, isn’t it?

Diversification requires a shake-up, a smarter approach.

The Clarity team decided to go back to the drawing board. Consider how investors perceive diversification, then create a thoughtful definition which incorporates part of the old along with important enhancements.

Clarity’s revised definition of diversification:

• A targeted selection of investments designed to manage risk within an allocation that’s behaviorally connected to who you are and the goals you seek to achieve. An allocation that fits the macro-economic environment driven by specific investment buy and sell disciplines.

That’s diversification for the new world, post-great recession.

Revised diversification strategies require actionable rules.

The following guardrails should help you identify and avoid the pitfalls that define diversification as it’s practiced in the field of financial services.

Watch for over-diversification. Too much of a good thing can increase risk. That’s not your objective. Do not allow your financial advisor to spread your investment dollars too thin: All you’ll do is create an expensive index fund alternative. The more investments you own, the more a portfolio may mirror or move in unison with the underlying markets (you can do that on your own in a less expensive manner).

Control the number of securities you own or add. Proper diversification can be achieved with as little as 5 to as much as 15 separate investment to represent stocks and fixed income options. You must understand the reasons behind every new investment. Is it additive to increase return or lower risk, or is it duplication of an investment you already own? Most likely it’s duplication.

You don’t need to own every asset class at all times to be diversified from a risk management perspective. For example, where is it written that a portfolio must always hold international stocks when most domestic or U.S.-based companies have formidable international revenue streams?

Why must small, mid, or large-cap stocks be eternally represented in a portfolio, never to be fully liquidated? An active approach to risk management may exclude several asset classes. Frankly, at times it may help returns and reduce risk.

Think outside the box for real diversification. For effective diversification consider passive income from rental real estate, development of human capital (your skill set) to increase earned income, perhaps fund a privately-held business (a riskier option). Remember ‘owning ketchup & oil’ through turbulent markets may not be an optimum risk management strategy.

And speaking of risk management…

Without a sell or rebalancing strategy, diversification can only go so far. This step is more work for your advisor, but that’s what he or she is paid for. To help minimize losses, a portfolio requires periodic rebalancing to take profits and a liquidation component to reduce losses that may be tough to recover from.

Beware the “lunch room effect.” You own 3 mutual funds from the same fund company, XYZ Financial. All have different names, different managers, and different objectives. Every day, the three fund managers have lunch. They discuss the weather, the hometown sports team, and their investment choices.

Manager # 2 based on the parameters of the mutual fund, likes what Manager # 3 has to say about Acme Corporation. She eventually decides, after further investigation, to add Acme Corporation to her fund holdings, too. This is stealth, industry-specific risk that destroyed tremendous wealth during the tech bubble. So the lesson here is to never own more than one mutual fund per fund group to avoid overlap.

The tendency is to perceive diversification a panacea, a Snuggie that allows portfolios to be forged then forgotten, as diversification is considered the ultimate free lunch (that’ll wind up eating your lunch).

Diversification today is also a convenient cop-out or weak replacement for risk management.

Schedule a meeting with your financial partner to discuss diversification.

Ask for a definition of diversification. See if you agree.

If not, it may be time to move on.

And save enough money through risk management to happily purchase your own lunches.

Richard Rosso, MS, CFP, CIMA