Diversify Intelligently

We’ve always maintained that consulting is more than numbers: Asset allocation must be grounded in current conditions, practical goals, and realistic time horizons, rather than dictated solely by top-down quantitative approaches, which, by necessity, rely on backwards-looking data. In other words, allocation decisions may be informed by quantitative inputs, but should not be dictated by them. Indeed, a purely quantitative approach to portfolio construction may lead to a proliferation of different asset classes, introducing unnecessary illiquidity and expenses and diverting attention from larger issues, even as it fails to produce a portfolio that performs as predicted. By definition, there is no reliable data from the future.

We recently read a new study concerning asset-class diversification and portfolio construction that we think worthy of summarizing here, not simply because it validates key portions of our investment approach, but also because, with markets remaining at potentially unsustainable heights, its findings are particularly timely.

“When Diversification Fails,” by Sebastien Page, CFA and Robert A. Panariello, CFA from Financial Analysts Journal examines correlations between asset classes in both strongly positive U.S. equity-market environments and strongly negative ones. Anyone who was invested during 2008 saw the extreme market declines in virtually all asset classes, which moved together in a single direction—down.

In their study, Page and Panariello examined asset-class correlations during U.S. equity market downturns between 1970 and June 2017 and indeed found that:

“Diversification fails across styles, sizes, geographies, and alternative assets. Essentially, all the return-seeking building blocks that asset allocators typically use for portfolio construction are affected.”

It has long been a truism that “diversification works until you need it the most.” Certainly that was true during the 1987 portfolio insurance debacle. Less well understood, perhaps, is that overly diversified portfolios not only fail to protect portfolios during downturns, they can also hurt overall performance in strong U.S. stock-market upturns. The study found that virtually all asset classes (other than domestic equities) were a drag on performance during strong U.S. bull markets, while hedge funds and international stocks actually demonstrated negative correlations—meaning the better U.S. stocks performed, the worse hedge funds and international equities did relatively. And, of course, neither provided any meaningful protection during downturns.

In short, diversifying a portfolio primarily by dividing it among an ever greater number of asset classes, as has become common practice, not only fails to provide risk mitigation during bad times, it impedes performance during good times. When we speak of the perils of “deworsification,” this is the reality to which we are alluding.

There may be—indeed, must be—good reasons for the presence of any particular asset class in an investment portfolio, but diversification simply for diversification’s sake is usually unproductive. It’s certainly not a reliable way to reduce risk.

True risk mitigation requires a multi-faceted approach that encompasses qualitative factors as well as quantitative measures. Accurately assessing a portfolio’s risk profile requires informed imagination; a discerning eye for unanticipated—and under recognized—sources of risk.

This has long been our favored approach, and one that has served our clients well through booms and busts alike for more than 45 years. Please contact us for a copy of the full article if you’re interested in reviewing the study’s findings in greater detail.

With seemingly every financial asset richly valued, we are often asked “what should we be doing since everything appears overpriced?” While we continuously monitor our clients’ portfolios and strive to mitigate risk, we would be pleased to review and discuss your specific investment posture should you wish.