Investing

The Benefits of Diversification

Diversification is one of the main pillars of successful investing. In large part, it has its origins in Harry Markowitz’s Modern Portfolio Theory, at least from an academic perspective. In actuality though, its a principle that has been in practice for centuries. Insurance companies and their predecessors understood the benefits of not putting all of their eggs in one basket. Many a companies and investors have failed as a result of over concentration in an investment whether it be a security, a person, a business or a property. Sadly, many employees that held large quantities of their companies’ stock (relative to their overall investment portfolio size) in 401(k) accounts and/or in their personal brokerage accounts were largely cleaned out when their companies filed for bankruptcy. Think Enron, Lehman Brothers, etc… The equity tranche of the capital stack is always the first to be written down.

As I continue to meet with more and more prospective clients and review their portfolios, I’m astonished at how many are invested 100% in equities via growth mutual funds primarily. Often there is some international and small cap exposure sprinkled in, but it’s all stocks, nearly all the time. Many of these individuals and couples are clients of the large brokerage houses we all know and recognize so well. I’m shocked at how clients’ interests are either not understood or take the backseat to other priorities, whatever they may be.

The Evidence

It’s been shown in practice and through testing that diversified portfolios offer investors the best balance of risk and return over longer periods of time. Think of it this way. If you have a portfolio of the asset of your choice and it loses 25%, you have to earn 33% from the trough to get back to breakeven. That assumes you were able to ride the portfolio down and stay invested the whole time. Not easy to do. If you had a portfolio that lost 50%, you would have to realize 100% return to get back to breakeven. Most of us would not be able to ride out a 50% loss in our portfolio.

Needless to say, volatility is the enemy of most investors. Think of volatility as the ups and downs in the investment markets. When they’re swinging up, we’re all feeling really good about our prospects and fill like geniuses. When they’re swinging down we have knots in our stomach with our finger on the sell button waiting for the signal to push it, which usually comes from our own emotions, in particular fear, a very powerful motivator.

With all of that said, it’s beyond me why anyone would be invested 100% in equities unless it was money a person didn’t need to touch ever and never looked at a statement either. Most of us don’t fall into that camp. We’re saving for retirement or to buy a home or to fund a college education. We need our money to work for us and to be there for us when we need it. We also need to set ourselves up to succeed. Understanding human emotion and how that drives asset prices as well as the decisions we make should lead us, or our financial advisers, to construct diversified portfolios with suitable allocations to stocks and bonds, at least, based on our individual circumstances (time horizon, risk tolerance, objectives, etc…).

Looking back historically, we can see the reasoning behind diversification. In the two figures below, we compare the peak-to-trough declines of a portfolio 100% invested in the S&P 500 and a portfolio 60% invested in the S&P 500 and 40% in 10-year U.S. Treasury Notes. Looking back 45 years, during the major draw-downs or declines in the stock market, the 60/40 portfolio lost about half as much as the 100% stock portfolio, on average. As a matter of fact, the 60/40 portfolio generated a compounded annual return of 9.24% versus 10.02% for the 100% stock portfolio. The telling factor here is the standard deviation of returns for the 100% stock portfolio was more than 50% higher than for the 60/40 portfolio. So over that time frame, you would have given up 0.78% of annual return with the 60/40 portfolio but would have theoretically been able to sleep better at night with less volatility of returns and smaller declines in portfolio value. You would have had a better chance of not make an emotion-based decision and potentially undermining your financial future.

The historical evidence supports diversification. Obviously, past performance is no guarantee or predictor of future performance. Furthermore, it’s easy to look at investment returns in hindsight but far more difficult to maintain perspective and discipline in the heat of battle for one’s financial security/success. At our firm, Glacier Investment Management, we educate our clients about the benefits of investment principles that have so far stood the test of time. We help our clients to understand and to be aware of their emotions and how at any moment these emotions can sabotage the best laid plans, potentially causing irreparable harm to investment portfolios. Through these efforts, we position our clients to have the highest likelihood of success in achieving their objectives.