Diversification: Too Much of a Good Thing

Diversification: Too Much of a Good Thing Investing, by its nature, is the goal of taking something and creating an environment in which it will grow. If done properly it will grow on a continual basis and the amount of growth received will reflect the amount of risk assumed in reaching for the growth. Some people selling investment advice speak and write frequently on "diversification" or "diversity within the portfolio" as if it were the goal of investing. Diversification is a tool to be used by the investor but is not the goal of the investment.

We have all heard about not putting all your eggs into one basket. Enron proved to us the real risk associated with this particular style of asset allocation, but many other baskets have been filled to the brim with the individual stocks of the company. Not putting your eggs into one basket is a great idea, very good advice. In fact we use multiple "baskets" for the assets we manage for our clients and depending upon the portfolio size we limit the total amount of baskets and the total amount in any one basket.

The "baskets" used in the investment business are no different. A CD basket is much different than a bond basket, which is different from a stock basket and so on. Even corporate baskets differ greatly. GE is very different than Ford, which is different than SouthWest Airlines, which is different than Caterpillar. Some people selling investment advice maintain all these baskets for diversity. This is the toolbox many advisors use and speak of in regards to the portfolios they manage but have seemingly forgotten what they were hired to do. An investment should be measured by the likelihood of making money. Any investment that is unlikely to make you money should be discarded.

The people who say you should own some of each investment "for diversification" are really telling you that they do not know how to judge and diffentiate a good investment from a bad one, or that they do not know what kind of investment climate we are living in. In one respect they are right. The less you know, the more you should diversify. If you are not very familiar with investing, you would be better suited to own some of everything and really spread the risk. But if this is the case, why do you need to hire someone who does not know any more than you?

The overall goal of investing is to make money. In order to do this you must, either take the time and energy required to learn how to do it yourself or hire someone to do it for you. If you had a crystal ball, you would simply select the one best investment and place all your assets there. This is an all or nothing strategy that works only with the help from an outside source and the crystal balls are only available in the movies. If you pick the wrong strategy, the one best place to put your assets, you could very well loose your investment. Improper diversification, over diversification or under-diversification, can have the same negative effects on a portfolio if not managed in an environment of thorough research.

For example, the S&P500 is an over diversified portfolio that most investors attempt to track in performance. Look at the overall history of the S&P and you'll see strong returns in specific market conditions while also realizing extreme volatility. Looking at information from Morningstar on the S&P 500, the diversity offered through these 500 holdings has not reduced the overall volatility. The 3-year average is a negative 11.42% as of the end of August 2003. The 5 and 10-year returns are 2.48% and 10.08% respectively. All of these return indicators have a standard deviation (measure of risk) well in excess of the returns, 16.56, 18.42 and 17.38 for the 3,5 and 10-year periods. Diversification should reduce risk and if done well should lower overall risk to a level well below the average rate of return. The indication here is that the over-diversified holdings within the S&P 500 have had the opposite effect, but the S&P seems to be the landmark by which most investors and investment advisors track.

As a mutual fund, the S&P 500 is a very poor performer. As a benchmark it also leaves much to be desired. It seems to go along with the all or none mentality in its returns with little middle ground. Investors that "buy and hold the market" are typically buying into an S&P index fund of some sort and have the long-term mentality that it will all take care of itself. In fact, I know many advisors who have the same mentality and allocation structure. Investors who hire these individuals seemingly receive the ultimate in diversification but with a minimum in research and knowledge by those who are hired to handle portfolios.

One suggestion comes from Warren Buffet, who is arguably one of the best investors of our time. He suggests that people would be well suited to limit themselves to 20 investment selections for their lifetime. He looks at the value of a balanced, well-allocated portfolio (diversified) but also thinks that time will take care of many issues. He has often stated that he does not care if the stock exchanges were to close for two years and is willing to hold good issues through price declines as much as 30%.

Most investors lack Mr. Buffet's insight and tolerance. They lack the confidence to choose the one or two best ideas, so for our clients we allocate across a multiple of asset classes that are well researched but we still limit the number of holdings. Too much diversification can hinder the portfolio as much as no diversification. We look at the market and economic environment, checking the current climate in which we live, to make well-informed decisions on the balance and allocation.

Understanding the process of diversification is part science, with logical analysis and research, and part luck in that a great deal of the movement within the investments is based not on logic but emotion. Diversification is a process that should be changing and evolving as the investment climate around us changes and evolves. What is the best strategy today very well will not be the best strategy tomorrow. Look at the bond market over the course of the past 3 years and see if that strategy is where you want to be for the coming year. This is an ever-changing environment, whether we are looking at bond or equity allocations. There are absolutely times to over allocate and under allocate specific asset classes to match the market and economic climate as opposed to simply placing yourself and your portfolio within a specific guideline because it fits some rule of thumb.

I am constantly asked about the percentage of allocation to equity and income for specific client profiles. There is, in my opinion, no snap shot allocation because an individual is a certain age or fits a certain profile. Simply because a 60/40 equity to income allocation is right for an individual investor overall does not mean that they must be 60/40 all the time. There are absolutely times when that ratio should be altered to reflect an 80/20 or 70/30 or even a 30/70 allocation based on the environment. Investors and advisors all think in terms of a singular basket (the overall asset allocation) and they all want to know what their baskets should look like in a static environment instead of looking at the baskets for the goal they serve which to is protect and grow assets.

Having the asset allocation baskets available is great but does not complete the picture unless one looks at the quality of the basket. Not specifically the quality of the holdings within the basket ( a subject for another article) but what the basket is structured to do. Not all baskets are created equal. A simple analogy: Easter baskets are designed to be dressed up and carry a few eggs that are already hard boiled, but they will do little to carry a full load of fresh eggs. A fiber basket is well suited for a dry climate but will disintegrate in a wet one. A plastic basket will cushion eggs in a warm climate but will break apart in a cold one. Different baskets serve different needs and different circumstances. A portfolio basket designed to grow assets in a strong equity environment will disintegrate in a moderate to strong down market.

Each portfolio is different as each individual investor is different. The diversification that should exist within each portfolio should reflect the goals and time horizon of the investor but the process of spreading out the risk amongst all assets is no more secure or advantageous than leaving holdings in a more concentrated position. Each investor should realize their comfort level with the quality of the holdings and more over should understand the knowledge level of the professional hired to help them with these assets.

Advisor is a Registered Principal of and offers securities through FSC Securities Corporation (Member SIPC).