How Many Baskets?

To pick up where we left off last month: Diversification, huh, what is it good for?  Well, most people would say a lot, that diversification is the foundational bedrock of an investment portfolio.  But also - and this next point might be somewhat controversial - nothing.

If you want to make money in the stock market - like, turn $1,000 into $100,000 money - you won’t do that with diversification.  Well, you will, but it’ll take 50 years. The quickest way to make money is by making a very small number of very large, concentrated bets...and then hopefully the bets pay off.  Think of any famous investor you’ve heard of, and they’ve probably made their money that way.

The problem is, it’s a huge gamble.  For every one investor you just named, there are hundreds that nobody has ever heard of, because they lost.  And then there’s the ones that made it to the big leagues and subsequently crashed into bankruptcy: Long-Term Capital Management, Amaranth Advisors, Marin Capital, Tiger Management, MF Global...the list goes on.  So sure, you can do all kinds of research/activism/questionably-legal market manipulating activities to try and make the gamble less of a gamble (*cough*hedge funds*cough*), but any investment with that kind of payoff comes with all sorts of risk.

That risk is exactly why the SEC, in their paternalistic omniscience, have limited most of the best investment opportunities out there to “accredited investors”.  For the vast majority of “non-accredited investors”, that level of risk is unacceptable. If your investments are in the form of a 401(k), or maybe you have a brokerage account but know you will be needing to use those funds in retirement, the possibility of losing all your money should never be on the table to begin with.  Yes, turning $1,000 into $100,000 a couple times over would be nice, but we’ll choose instead to take the worst possible outcomes off the table and make money the old-fashioned way: savings and time. And so we turn to diversification. Diversifying will not make you money, but it will certainly mitigate potential losses.

What exactly are we diversifying? The portfolio, yes, but more specifically, we are diversifying the risks that the portfolio is exposed to.  Consider a portfolio that is 100% Apple stock.  Clearly, not very diversified. Returns have been excellent, but suppose the new iPhone 11 goes all Samsung Galaxy 7 spontaneous combustion.  Goodbye returns.

Now consider a portfolio of 5 stocks: 20% each of Apple, Google, Samsung, Facebook, and Amazon.  That’s more diversified, because you are less exposed to those Apple-specific risks. You even have some international exposure from Samsung!

But consider a different portfolio of 5 stocks: 20% each of Apple, Home Depot, AT&T, Exxon Mobil, and JP Morgan.  Those are all US companies, but might you consider that portfolio to be more diversified than the all-tech portfolio?  We certainly would. 

You can actually calculate an answer to that question using the correlations between the various securities.  We won’t bore you with the details, but yes, that second portfolio is objectively more diversified than the all-tech portfolio.  And even more diversified would be a portfolio of Apple, Home Depot, AT&T, JP Morgan, and Treasury bonds.  See where we’re going with this? The more part of your portfolio zigs while the other part zags, the lower the overall portfolio risk and hence the “better” the diversification.

(Geeks note: Ideally then, this means that there will always be part of your portfolio that is making money.  Somewhat counterintuitively, it theoretically also means that there should always be part of your portfolio that is losing money, since negative correlations offer stronger diversification than zero correlations.  In practice, however, most people look for noncorrelation rather than negative correlation in order to target higher overall portfolio returns.)

Back to portfolios as a whole.  Let’s say your portfolio looks like this:

25% US Large Cap ETF
10% US Mid Cap ETF
10% US Small Cap ETF
25% Developed International ETF  
10% Emerging Markets ETF
10% Healthcare ETF
10% Dividend ETF

Is that diversified?  You’ve got 7 different ETFs, each one of which holds a few hundred individual stocks.  You have exposure to every sector and every possible country of the world’s markets. That’s about as diversified as you can get...within equities.

There’s a saying that correlations go to 1 in times of market stress.  So while you have a diversified equities portfolio there, that’s not going to do much for you in the face of another 2008-style crisis.  So let’s tweak it a bit:

25% US Large Cap ETF
10% US Mid Cap ETF
5% US Small Cap ETF
15% Developed International ETF
5% Emerging Markets ETF
40% US Treasuries

60/40 portfolio, anyone?  That’s better, from a diversification standpoint.  The Treasuries position should go up if stocks are getting hit with another 2008-style crisis.  But…

What if the next crisis isn’t caused by banking activities but instead by, say, an inflationary shock?  Well, then you’re not really diversified because an inflationary shock would make that Treasuries hedge drop right alongside those stock positions.  Oops.

The tricky thing about diversification is that it changes depending on what risk prism you’re looking through.  Portfolio construction then, becomes part science and part art - art, to imagine the various risks facing a portfolio and then construct in such a way as to minimize the impact of any individual risk while simultaneously maximizing potential return...and then constantly reassess.

That constant reassessment is one reason we don’t subscribe to a traditional “buy and hold” investment approach at the moment.  You may have a perfectly diversified portfolio given the current environment, but we can pretty much guarantee the current environment will look different two years down the road.  Shouldn’t your investment portfolio change with the risk outlook?

Those of you who are clients might recall that for the majority of 2017 and most of the first half of 2018 your portfolios were 85-95% equity - very similar, in fact, to the all-equity portfolio we seemingly disparaged about a page ago.  That was because we didn’t see any immediate risk to stocks, and there is nothing like equities for generating return. As risks increased in both scope and proximity, we diversified away from that amount of equity risk with negatively correlated assets (US Treasuries) and non-correlated assets (gold).  If and when those risks diminish, we fully expect to increase equity exposures once again to take advantage of the returns that equities offer.

Diversification is a necessary component of investing when you’re dealing with money you can’t afford to lose.  But ultimately, it’s a tool. And like any tool, sometimes it’s more useful than other times. The trick is in figuring out the when, the why, and then the real kicker is the how.

We’ll close with a quick, mildly-related observation on risks and returns.  A few months back, we wrote a note (The Return of Voldemort), which looked at the terrible track record of IPOs so far this year.  Well, now you can add Peloton and WeWork to that list. In fact, WeWork was such a disaster it never happened.  We(Didn’t)Work. And as for returns...we’re headed into the fourth quarter tomorrow, so you’ll likely hear a lot in the coming months about how the market did in 2019.  As of today (9/30), the S&P 500 is up about 20% year-to-date, since Jan 1. Which sounds really impressive, but let’s zoom out just a little bit. As of today (still 9/30), the S&P 500 is up only 4% in the last twelve months, since Sep 28 last year.  The Dow is up less than 2% in a year, NASDAQ is actually negative since this time last year, and small caps are negative by almost 10%. Just a little something to keep in mind while you listen to the talking heads tell you how awesome everything is.