Problem: You are not as protected through traditional diversification as you might think. The conventional wisdom behind diversification is that if you spread out your risk to numerous holdings and asset classes, they will all be moving up and down at different times, thus reducing the risk of a major decline in your portfolio. However, what if this isn’t true? What if all of your investments are set up to move in sync with each other?
As we will examine, there is a good chance that all of your stock positions mirror each other’s movements. If this is the case, you may not be as protected through conventional diversification. Thus if your large-cap fund declines, the odds are that your mid-cap fund will follow suit. How does that help you?
First, the Importance of Asset Allocation: Around 91.5 percent of an investor’s return will be due to the specific asset classes that he or she invests in (e.g., large company stocks, government bonds, real estate, etc.), rather than any specific investment or fund he or she may choose. This lends further credence to the idea that choosing a specific fund manager for a specific asset class is less important than you might think. Rather, what is important is the asset class itself. This conclusion has led many pension and endowment funds to develop their strategies around sound asset allocation. Diversification through proper asset allocation is one of conventional wisdom’s most common pieces of advice that it recommends to help investors reduce volatility.
The following chart shows the performance of a select list of asset classes from 1998 through 2012. The highest performing asset class is shaded for each given year. Spending a few minutes analyzing this chart will provide you with the following insights. One, there are more asset classes than you might have assumed. Two, performance numbers for asset classes will vary in any given year. Three, Israelsen noted in the last three columns the flaw of trying to chase performance by selecting the asset class from the previous year that performed the best. Again, I often witness people making this type of decision within their 401(k)s, but it also leads to massive underperformance.
Over time, as certain asset classes underperform, the idea is that others will outperform. Thus the volatility (the standard deviation or risk) of your portfolio will decrease. Reducing volatility is perhaps undervalued because with increased volatility comes the potential for irrational investor behavior, which studies have shown can lead to the significant underperformance of the overall market. In theory, asset allocation alleviates a lot of these emotions by reducing the volatility of an overall portfolio.
Again, the challenge to investors, in order for this strategy to work best, requires unemotional commitment. After all, the reduced volatility is a result of something that is counterintuitive to many investors’ mind-sets. In an efficient asset allocation, there most likely will always be an underperforming asset class providing little to no (perhaps negative) return. But remember, just because one asset class is down doesn’t mean you should remove it from your portfolio; it may be a strong performer in the subsequent year as markets change.
*Source: Craig L. Israelsen, PhD, 7Twelve Portfolio, www.7TwelvePortfolio.com.
Most investors don’t have detailed asset class analysis like that provided by Israelsen. Unfortunately, I believe a disservice is done when the average investor gets a watered-down version of asset allocation. Take for example the asset allocation tool courtesy of Money magazine, which can be found here: http://cgi.money.cnn.com/tools/assetallocwizard/assetallocwizard.html.
All you have to do is answer four questions. I answered these questions with the mentality of an average investor with a moderate to moderately aggressive risk tolerance (not conservative or aggressive). As a result, the recommended portfolio was this:
Running a ten-year correlation analysis reveals some surprising results. It shows that large, medium, small, and international don’t offer the investor much in the way of diversification benefits. Using four Vanguard Index funds (S&P 500 for Large-Cap VFINX, Mid-Cap Index VIMSX, Small-Cap Index NAESX, and Total International Stock Index VGTSX), we can analyze how correlated one stock index is to another. If you compare one investment to itself as represented on the matrix, it will be a 1:1 correlation, or a 1.0. We find that the least correlated asset classes are small caps to international. That pairing still has a correlation of .86, which means that it is still highly correlated.
In the past, owning these different types of stock asset classes may have provided good diversification. That is no longer the case. If we head into a bear market for stocks, whatever percentages you allocated to small, medium, and large companies may matter very little, as they will most likely all decline. In other words, when one stock goes up, they all go up. When one goes down, they all go down. As the saying goes, “When the tides go out, all the boats sink.”
LC MC SC INT
LC: 1.00 0.95 0.92 0.90
MC: 0.95 1.00 0.97 0.90
SC: 0.92 0.97 1.00 0.86
INT: 0.90 0.90 0.86 1.00
LC = Large-Cap Stocks
MC = Mid-Cap Stocks
SC = Small-Cap Stocks
INT = International Stocks
(Source: iShares Correlation Calculator, 2012 through 2012)
In the previous pie chart, we now know that 70 percent of this portfolio (which is allocated to various types of stocks) is highly correlated, and it provides little protection through diversification. So how can you do better and what should you consider for your own portfolio? To reduce the risk of volatility within portfolios, we need fewer correlated asset classes. To do this, we need to go beyond just stocks and bonds by adding a third core asset class: alternatives (discussed in chapters seven and ten of my book).
Points of Emphasis to the Individual Investor:
- There is now a high correlation between large, mid, small, and international stock indexes. This can be very misleading when choosing your portfolio options within your work retirement plan. Choosing from limited options to begin with, the list of offerings provided under each of those four asset classes gives the investor the illusion of diversified investment choice. Unbeknownst to them, they may all produce similar results.
- The asset classes you choose for your portfolio matter much more than the fund manager or Morningstar rating. If you are savvy with Morningstar or Yahoo Finance mutual fund filters, I challenge you to examine how many mid-cap or large-cap funds, for example, performed drastically different than their indexes in recent years. As you do these filters, it will become apparent how closely they all behave to each other.
Tim Higgins, Author of Paying for College Without Sacrificing Your Retirement and Unconventional Investing