(C) Sam Burt 2010

((C) Sam Burt 2010)

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Surprised by Diversification

Today’s investment landscape is steeped in a broad tradition of portfolio diversification and there exists many helping hands to guide you in separating your personal riches amongst various diversification levers marked large cap, small cap, value,  growth and international.  The bond exposure is spread out similarly with corporates and governments helping smooth out the diversification style box.  Yet, many time-honored asset allocation models, despite incorporating a litany of funds, styles and strategies, simply fail to diversify the underlying risk at hand.

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Up until the late 1960’s investment diversification was considered reckless -- borderline improvident -- as no self-respecting investor could possibly manage investment affairs scattered like a bag of marbles sprawling across a tiled kitchen floor. Investment ethos held fast to Andrew Carnegie’s wisdom on placing all your eggs in one basket and then watching that basket closely; resisting anything otherwise until academic contrarians including Harry Markowitz and William Sharpe proselytized the financial world with theories on financial markets, diversification and risk; financial knowledge, similar to medicine or physics, ultimately was incorporated into mathematical constructs and models.  In the grand scheme of financial history, any economic virtues of portfolio diversification steadily morphed from an intellectual novelty to a full-fledged industry where we presently stand wrapped within a sheer multitude of choices and selections.  All in the name of diversification.

Failing Diversification

An unprecedented number of financial crises have arisen in the past few decades. Without the benefit of hindsight, who could have predicted any of the turbulent market conditions over the preceding forty-plus years? The list is formidable, including the breakdown of the Bretton Woods Agreement, the first oil crisis of 1973, Black Monday, the Japanese stock market crash, the collapse of Long-Term Capital Management (LTCM), the Russian ruble crisis, the Asian currency crisis, 9/11, Hurricane Katrina and the 2008 credit crisis -- Great Recession. These extraordinary events have had both short-term and long-term effects on market volatility. And, what lies similar in all of these events is our initial reaction to them.

We reside in a long-bias investment world and thus, what transpires during a crisis is fairly simplistic.  Risk-limits are stretched, individuals and institutions rush to sell and hastily herd into other asset classes for safety.  The end result being equity and bond volatility spike simultaneously -- as common assets tend to cluster together precisely when you are praying otherwise.  The fallout continues as correlations will rise sharply as most crises don’t discriminate -- everything is being sold below wholesale -- testing you and your resolve to maintain your long-term financial mandate.

If lack of true diversification represents the first failure -- the balancing of those potential risks is a very close second as balancing exposure (amongst sectors, styles) simply may not be enough.  Other words, seeking to allocate portfolio exposure across distinctly different risk/return drivers and shocks should be of paramount importance.  Employing this portfolio strategy should broaden your diversification, lower your portfolio volatility, softening the blow of the next rare event while keeping your emotions from making a regretful decision.

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Define your diversification

Imagine yourself a third-generation carnival operator who tours state fairs across the Midwest with the expectations of providing safe, reliable enjoyment with the 10 amusement rides you haul on the back of your tractor trailer fleet.

Before your summer season begins you walk into an insurance agency to purchase one-year accident insurance on your portfolio of amusement rides.   The insurance company estimates the chances of accidents and after some negotiations you sign the contract.  The situation here is vaguely reminiscent of you and your portfolio.  With some imagination consider the insurance company to be “short volatility” and the carnival owner “long volatility." However, here is where the confusion lies as market volatility doesn’t really pertain -- in fact, it doesn’t exist.

Each accident is a random event depending on an uncountable number of external influences.  There is not enough information to calculate changes of the ride accident probability at state fairs on a time scale of several months, not to mention its volatility.  Moreover, its volatility does not matter, as both sides have purely directional bets.  It will be the accident probability itself that will matter, not its incalculable volatility.

For the carnival owner a mishap on the bumper boats has no direct influence on the reliability of the double shot or swing boat ride.  And, in most market environments, those parallels remain true so far as what happens to your bank sector holdings may be independent to the returns generated by your consumer discretionary stocks.  You are diversified but relatively so as you need exposure to asset classes with positive and negative exposures from the current state of market equilibrium.  Your worry should be focused on all of your rides (i.e. investments) malfunctioning simultaneously and persistently.

Diversification with diversification

Suppose I offer you an investment proposition whose possible loss over some time period is 100%, while you can only manage to stand a 2% loss.  If you like the prospects of this investment, the solution would be to invest just 2% of your money and keep the remaining 98% in cash.  Simply, the only thing important in an investment portfolio is not its standard long-term volatility, but its vulnerability to catastrophic events or, higher moments and co-associations.

True diversification critically hinges on the underlying risk and/or the awareness and likelihood of two asset classes changing in conjunction to one another. Principal, hopefully uncorrelated, sources of risk in well-constructed portfolios need to range beyond simple vanilla equity styles.  Embracing your portfolios sources of risk and return is the beginning of true diversification.

 

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