We commonly think of asset classes (stocks, bonds, real estate, etc…) when we think of and discuss diversification. However, there are other important forms of diversification that can enhance the risk-return profile of an investment portfolio. Specifically the diversification of investment strategies is one important area all investors, where possible, should consider.
There are many types of investment strategies that are likely well-known among the masses and others that might not be as well known. Some are available to all investor types and others might only be available to investors with larger amounts of money to invest or that are considered accredited (Note: An accredited investor meets certain annual income and/or net worth requirements which suggests, at least legally, he/she is better capable of understanding and making what are perceived as higher risk investments).
For purposes of this post, an investment strategy follows a predefined set of criteria and/or procedures in selecting individual investments to include in an investment portfolio. For example, passive investing and active investing are investment strategies. As a reminder, passive investing is a strategy that seeks to replicate the performance of an index or benchmark while active investing deviates from the market or benchmark in an attempt to generate greater return. For your information, the term investment style is often used interchangeably with investment strategy. While there may be differences between the two in the eyes of some, a discussion of those differences are beyond the scope of our post today.
Mixing It Up
In previous posts, we’ve highlighted the benefits of passive investing as well as the historical evidence that supports a passive investment strategy. We’re going to build upon those principles in our discussion of investment strategy diversification. While a passive investment strategy has generally proven superior historically to an active strategy, active investment strategies offer various diversification benefits. The mixing of passive and active strategies can result in better balanced, higher return profile portfolios if constructed and managed properly.
The goal in portfolio construction is to build a portfolio of investments that will provide you with the necessary growth while allowing you to sleep at night and to not head for the exits when the excrement hits the ventilator (courtesy of William Bernstein via Bloomberg Radio). In other words, diversification is not only a portfolio management tool but it also serves as a behavior management tool of sorts. We all need to be willing to give up a little bit of short-term return in favor of a less volatile investment portfolio where we will stay invested and as a result have a much higher probability of achieving our goals, whatever they may be.
A portfolio that only implements a passive investment strategy will go up and down with the investment markets, offering no reprieve or counter-move in a correction or bear market. This can be problematic for an emotional investor (Note: most of us fall into this category). Complimentary investment strategies such as long/short and/or trend-following could potentially help to offset some of the paper losses experienced during market downturns. Nothing is guaranteed but different investment strategies have the potential to offer uncorrelated returns across different market environments. The key here, as with any successful diversification strategy, is to allocate to uncorrelated investment strategies.
Not All Active Investment Strategies Are Created Equally
While there are many active investment strategies, not all offer diversification benefits. As we’ve alluded to in previous posts, many active strategies are highly correlated with passive strategies and thus don’t provide any real benefit, either from a diversification or a return perspective. Many of the well-known and most common investment strategies such as growth, value, large cap, small cap, etc… don’t offer the diversification benefits which are referred to in this post. These individual strategies are so well known and ubiquitous any more that they’ve become highly correlated with market returns and don’t offer any real excess return opportunities either. You end up paying a higher fee for market returns, if you’re lucky.
Don’t fool yourself, it can be quite challenging to find an uncorrelated investment strategy and even more difficult to find a good manager of that investment strategy. Make sure you do your homework and rely upon a robust body of evidence when determining to allocate a portion of your portfolio to an active strategy. In the end, you want strategies that zag when the core part of your portfolio zigs.