Philpot’s BottomLineTips: Diversification

The title itself indicates this could be a very boring topic. Just the title alone has 15 letters and ends in “tion” which is pronounced shun, and that is exactly what many investors do — they shun this topic. Taking an adverse stance toward diversification within a portfolio can certainly lead to disastrous results.

Diversification is referenced many times in the Bible, especially in Ecclesiastes. If so inclined, you might want to read through this very interesting book to find the references to diversification (a very sound principle). This principle is synonymous with the saying,  “don’t put all your eggs in one basket.”

One well known example of diversification can be found in the historical account of Christopher Columbus sailing to a new trade route to Asia.

He made this first voyage on three ships, the Nina, The Pinta, and the Santa Maria. The Santa Maria was the flagship, the one that Columbus himself captained. She was a big, slow ship designed for carrying heavy loads. The Nina, was a small ship. She was what was called a caravel. Because of her size and speed, the Nina would have been the best ship to sail against the wind. The Pinta was also a caravel, which was also light and fast, the fastest of the three ships.

The ships sailed from Spain in August of 1492.  After discovering America in October 1492, the Santa Maria was wrecked off of the island of Haiti. Strong storms accosted the Nina and Pinta on their homeward voyage and they became separated. Eventually both of these ships made it back to their home port of Palos in March of 1493.

Columbus, a very experienced and courageous sailor chose to Captain the Santa Maria; however for all of his skills and experience this ship was lost. Columbus and his men had to switch to the other ships to carry them safely back to their home port.

Asset allocation or portfolio diversification is meant to accomplish the same task. Even though a particular sector or asset class might be deemed to be more favored or considered to be a higher weight anchor of the portfolio, it is often the lesser, smaller assets classes in portfolio construction that carry the portfolio through the toughest, most dangerous times in the markets.

Diversification, in its most simplistic form is not very complicated; it is simply adding several asset classes to an investor’s portfolio. Asset allocation; however, properly constructed, is steeped in complex time tested mathematical formulas. Just check out any writing by Harry Markowicz, the father of modern portfolio theory. Not being a great mathematical student myself, reading any of Harry Markowicz’s works send me reaching for the pain reliever. I understand what he does and I understand the theory, but I must admit I certainly get lost in the mathematical formulas to derive at the proper asset allocation.

Let’s go back to the story of Christopher Columbus. What if he had only taken one ship, the Santa Maria? What would have happened to him and his men if that was the only ship upon which they relied? Columbus later noted in his journal that she was very heavy and not suitable for the business of discovery. After changing to the Nina to bring him back home, this ship became his favorite and the Admiral sailed on her several more times.

The markets (both bond and equity) have had periods of extreme volatility over the past decade, especially in 2008. During the past few years as the news headlines seem to be screaming that the sky is falling and investors become paralyzed and hoard cash, or have a desire to rush into gold with entire portfolios, I am reminded of the reverse situation during the decade of the 1990s. The news was good and getting better every day. Every day an investor was making money just by throwing a dart at the stock section of the newspaper.

Just like investors now stockpiling cash reserves at zero percent or investing in gold at its highest point in decades, the investors then were scrambling all over each other trying to get their money invested in technology stocks before they went up yet another day. It seemed there was no limit to how high they would go nor did there seem to be an end to the analysts continued buy ratings. Amazing considering a lot of these companies weren’t even making money yet! I should have known the end was soon in sight as my phone never stopped ringing for me to buy someone another lot of Cisco Systems or Lucent or one of the new dot coms. It was panic, but back then it was  buying panic; recently it has been selling panic.

Diversification in the 90’s meant buying more than one technology company. Who wanted to own a bond back then paying 5% or a good utility stock with a good dividend that might only go up ten or fifteen percent?

I’ll never forget the day I was fired in the late 1990s during the technology frenzy by a client who had money at another brokerage firm. His return was more than 70% in one year invested all in technology stock. I would not allow my clients to invest all of their portfolios in technology stocks and that year his diversified account returned over 50, but 70% was better than 50% so I lost the account. (Past performance is not an indicator of future results.)

Well, as we all know, when the equity markets including the technology sector which was the hardest hit did come crashing down investors went scrambling into those investments once considered out of date and behind the time like treasuries, CDs, and bonds. Even utility stocks with nice dividends became attractive again. The investors who had stuck to their asset allocation model, or who had advisors that did not get caught up in the new normal of the day didn’t get killed on the way down. True, they had not experienced the huge upside of the technology bubble, but neither did they feel the pain of the entire collapse. Just like Columbus who lost a ship and unfortunately some men, those investors had other investments that allowed them to rebuild and forge ahead toward their financial goals.

What happens when an investor has a properly allocated portfolio? At times, the flagship position or core position, usually large cap U.S. stocks provide a steady base and may experience the greatest growth. At other times, this asset class may underperform while small cap stocks experience the greatest upside. Yet at other times, bonds or international stocks, or commodities may experience growth while other asset classes underperform or produce negative returns.

Asset allocation does not ensure that one will not experience periods that the entire portfolio performs negatively. 2008 is a perfect example of all asset classes producing negative returns. So does that mean that asset allocation doesn’t work in periods like 2008? I would argue to the contrary. Rather than suffer a 40% or greater loss as many portfolio suffered during that very recent year, the loss in a properly constructed asset allocation model was not as great. If losses can be lessened in the periods of downside volatility, the upside required to get back to even also does not have to be as great.

Check out a Callan Periodic Table of Investment Returns (link here to the PDF). This table will reflect by color the various asset classes. If you were to just concentrate on nothing but the color scheme, one main factor stands out, and that is that the colors go from the top to the bottom.

Often, the asset class that was on top the last year, or consecutively on the top for two or three years or more will drop all the way to the bottom in a subsequent year or years. A great example when looking at the Callan chart is that the Emerging Markets sector outperformed every other sector for five consecutive years, 2003 through 2007.

Individual investors notice this trend so money flows into this sector because it was the best performing sector for a long time. As these investors flock to this sector, they often sell out of the Barclay’s Aggregate Bond sector because it was the worst performing sector for four of those same five years. “Reversion to the Mean” now occurs and to the amazement of many individual investor’s, the Emerging Market Sectors falls to the very worst performing sector the very next year and the Barclay’s Aggregate Bond Sector gains momentum and moves to the very top of the chart in 2008 as the equity markets tumble. This is a proven behavior pattern of individual investors.

In general, the individual investor will make the wrong decision. Why? Research shows that many individuals invest with their emotions, not with discipline.

Diversification, or asset allocation, is not merely mixing together a lot of asset classes. Any great cook knows it’s not just the ingredients that produce a great result; rather it’s the right amount of various ingredients that bring about the desired flavor and texture.

The same can be said for designing a portfolio allocation. It takes the right amount of various asset classes to produce the optimum amount of risk and reward. If you don’t believe me, just read one book written by Harry Markowicz.

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Carolyn Philpot can be reached at [email protected]

Required regulatory note: Securities offered by 1st Global Capital Corp. Member FINRA, SIPC. Investment advisory services offered through 1st Global Advisors Inc.