Diversifying Your Portfolio For Risk-Adjusted Returns

Includes: AGG, SPY, WDTI
by: Efficient Alpha

By Mario Mainelli

This continues our series of articles written exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling.

The myth on today’s menu is that “diversification lowers returns.” The idea behind this common misconception is that when you diversify, you have parts of your portfolio winning and parts of your portfolio losing at all times, which will lower returns. Sure, diversification will seem pointless if you’re fixated on a single market that is outperforming your diversified portfolio. Most people reading this article are likely fixated on U.S. equities. Therefore, during a strong bull market in U.S. equities, a properly diversified portfolio will lag in performance. Why diversify across multiple “return drivers” (which are discussed extensively in “Jackass Investing”) when equities are soaring high? The financial meltdown of 2008 answers this question for us. Had you been riding just equities, you would have seen hard times. In fact, many did.

The S&P 500 ETF (NYSEARCA:SPY) dropped from $129.51 on August 22, 2008 to $88.5 on October 10, 2008. A drop of such drastic proportions would make even the most risk-inclined investors sick to their stomach. Contrarily, the Rydex|SGI Managed Futures Strategy (RYMFX), a fund diversified across many markets using a trend following strategy, actually increased in the same time period, from $26.05 to $28.79.

Before we dig further into this myth, here is a cliff’s notes version of diversification as preached by modern portfolio theory. Perfect portfolio diversification will eliminate unsystemic risk (the risk attributed to a specific security) but it will not eliminate systemic risk (the risk of the market as a whole). While diversification will not eliminate systemic risk, it will lessen its affects.

There is one serious flaw in this theory. It is intentionally self-limiting. It assumes that diversification is restricted to the commonly accepted “asset classes” as explained in a prior article in the series. If that is the case, then it is accurate that diversification cannot eliminate systemic risk. But diversification across return drivers can not only reduce systemic risk, but unsystemic risk as well.

Once return drivers replace asset classes, “true” portfolio diversification can be achieved. The benefit of this is that your portfolio will spend more time making new gains and less time recovering from losses. For this reason a truly diversified portfolio will outperform a less diversified portfolio. For example, consider a person who had his entire portfolio ‘invested’ in SPY while it lost half its value in the 2008 financial crisis. That person requires their portfolio to gain more than 100% just to get back to its initial level. As we can see, it is difficult to get back to the breakeven point after a loss (the greater the loss, the higher the degree of difficulty). A truly diversified portfolio is considerably less likely to suffer a loss, and when it does suffer a loss, the loss will be considerably smaller than its non-diversified counterpart.

In fact, as an extreme example, the author demonstrates the power of diversification by combining two losing portfolios to create a winner. It may sound far-fetched, but actually can be done. The S&P 500 and the Inverse of the S&P 500 produced total returns of -9.1% and -10.8%, respectively, over the 10 year period between 1999-2009. Two losers, indeed. However, when combined, we see the true magic of diversification. Abracadabra! The combined portfolio actually produces a positive total return of 1.7%. Not too shabby considering it is made of a combination of two losing positions. To quote Dever, “Portfolio diversification is the financial equivalent of magic.” We can definitely see some truth in this quote, based on this example.

A diversified portfolio is certainly no get-rich-quick scheme. You will probably not double your money within the first couple of years. You will, however, slowly and safely accumulate wealth, while still being able to sleep at night. The two recent financial meltdowns serve as a reminder of the importance of a properly diversified portfolio. These two financial crises would have put most non-diversified portfolios in serious jeopardy. A properly diversified portfolio (aka one with exposure to a number of different return drivers) would not have been hit nearly as hard by these crises.

Next, I’ve decided to provide some insight on barriers of diversification and how we can overcome these “barriers.” I recently came across an article titled Equity Portfolio Diversification (pdf), written by William N. Goetzmann and Alok Kumar. The authors conducted a study of more than 60,000 discount brokerage portfolios and found that the portfolios were immensely under-diversified. The biggest offenders of under-diversification were younger, lower income investors that belonged to the non-professional job category.

The authors attributed this lack of diversification to the following factors: low income, high transaction costs, high search costs, and an undeserving level of overconfidence. I would add a fifth factors to this list: conventional investment wisdom does NOT preach true portfolio diversification. With the fixation on finding “Dream Stocks at Affordable Prices” (an actual article referenced in “Jackass Investing”), the mainstream financial press hypes the upside of – primarily – owning stocks. It does not preach the much more valuable use of diversification across disparate return drivers to lower risk (which, as shown in the above example, also serves to increase returns). It is unfortunate, because some logical thinking can disprove these “barriers” to diversifying.

The first three are easily disproven by simply considering ETF’s. ETF’s are a great low-cost way of diversifying even the smallest of portfolios. ETF’s have become extremely popular over the last decade, but investors still fail to use them for proper diversification. Sticking your funds in one equity-based ETF is not true diversification. Despite having numerous securities, the stocks held in these ETF’s are dependent on the same primary return drivers as shown in the first article of the series. We may seem like a broken record, but we cannot stress this point enough. For proper diversification, you will need to expose your funds to various return drivers.

Diversification can be easily achieved with as few as three ETF’s: a managed futures fund which provides exposure to various commodities, currencies, and financial futures like the WisdomTree Managed Futures Fund (WDTI); a fixed income fund which provides exposure to international and/or domestic bonds like the iShares Barclays Aggregate Bond Fund (AGG); and an equity-based ETF which provides exposure to international and/or domestic stocks like the S&P500 SPDR mentioned above.

One indicator that these ETFs are each powered by different return drivers is their relative “betas.” The beta of a security is one measure of correlation in that beta shows the relationship between each security and the U.S. stock market. A beta of 1 implies the security moves exactly in line with the market; a beta of greater than positive 1 implies the security will move in the same direction as the market but in a greater proportion; a negative beta implies the security moves in the opposite direction as the market; and a beta of 0 implies no correlation to the market.

The fourth barrier, overconfidence, may be a little more difficult to overcome. Investors tend to believe that the information they have on a stock is unique to them. For example, an investor may learn that a company has reported earnings that have beat analysts’ estimates and become overconfident in the stock. Such an investor will feel less of a need to diversify, due to how sure they are of the stock(s) they own. A company beating an earnings estimate is definitely a positive thing, no arguments there. Nevertheless, it is not a good enough reason alone to buy a stock and certainly should not be a reason to fail to diversify. The efficient market hypothesis will tell us that all public information about a stock has already been reflected in its price. Thus, the stock is less of a bargain then you would think.

Finally, the fifth barrier that I presented makes it clear that if you continue to follow conventional advice regarding portfolio diversification you will continue to produce similar unsatisfactory results. As Mike Dever states in the Epilogue to “Jackass Investing,” you are left with “two clear choices: continue to do what you’ve been doing and hope for different results – this is Albert Einstein’s definition of insanity – or change your approach.”

I hope the above has really driven home the necessity of diversification. Holding under-diversified portfolios in the short run may produce positive returns, but odds are that you will get burned in the long run. With the recent financial crises fresh in our minds, diversification should be a no-brainer. My advice is to set up your portfolio to rationally and strategically diversify your funds across a variety of return drivers. For an example of such a portfolio, please see my previous article, How to Remove Familiarity Bias from a Portfolio. Don’t let these so-called “barriers” obstruct you from creating a portfolio that will allow you to safely achieve your monetary goals. See our website for a complete list of the articles within the series and other strategies to achieve a truly diversified portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.