Is diversification enough anymore?
Originally published in Business Pulse Magazine Winter 2017 issue.
It is of common belief that diversification is seen as the only free lunch for investors. It’s an easy concept for clients to grasp, a simple tool to implement. And many financial advisors have steadfastly used it for decades as their primary tool in avoiding concentrated risk while also reducing risk to any given security or asset class.
So what’s the problem? Unfortunately, most financial and investment professionals are sales-driven rather than outcome-oriented, and their main value proposition is to help you diversify your portfolio because it’s all they understand.
The term diversification often is referred to as Asset Allocation or Modern Portfolio Theory (MPT). I call this building an investment pie – the least tasty kind of pie. Basically, Asset Allocation is how a majority of 401(k) plans invest your retirement assets using age-based rules such as 80/20 (80% stocks, 20% bonds) for young individuals and 30/70 (30% stocks, 70% bonds) for retirees.
Diversification gets overused as a method to soothe clients’ desire for risk aversion. Discussing investments is a heavy-jargon topic that’s complicated and even daunting for many clients who want to plan their retirement.
The feeling of anxiousness in making your money work for you toward a payout in 25 years needs a salve. The problem is that over-diversification waters down the gains with losses over time.
This leaves clients’ accounts vulnerable to broad economic systemic risks (undiversifiable risk).
Why? Our economy and financial system is significantly different today due to monetary, fiscal, regulatory and other forms of government intervention or manipulation. An amount of undiversifiable risk will always be present in the market regardless of the amount of diversification in a portfolio.
This means risk will also be present at the portfolio level, no matter what. It would be irresponsible to assume that what worked 20 years ago will work today.
When striving to elevate clients’ investment portfolios we need to go beyond simple diversification alone. In order to do so requires extensive time, research, and analysis which might be why it’s not as common.
Most portfolios feature flat, two-dimensional designs with no ability to adjust or adapt to risks and opportunities. Portfolios should be designed in a three-dimensional matter where we bring together new techniques and management styles to portfolios, and not just use different assets classes.
A three-dimensional portfolio incorporates active management styles such as momentum or contrarian strategies, but passive investing methods as well. This is an important concept because no single strategy is the Holy Grail.
Personal investing is all about building a portfolio of different buy/sell mechanisms to either take advantage of opportunities or protect against risks. If the goal of diversification is to smooth out returns, it’s my belief that simple portfolio allocation falls short. The value added from using a multiple-strategy, three-dimensional framework is what clients expect, but too few get offered that.