The Importance of a Truly Diversified Investment Portfolio

Most of you reading this article probably think you understand what diversification means. I'm here to tell you that, more than likely, you don't. My experience leaves me no other choice. Most Americans think they understand the concept and virtually all of them think they're the owners of diversified portfolios. They don't and they aren't. This misconception has become so prevalent that the term "diversification" has almost become a dirty word. I'm constantly hearing from people that diversification doesn't work. They tell me that they had a diversified portfolio, but they still lost thirty percent of their assets in a downturn. What do these people have in common? They weren't actually diversified.

If you own six different blue chip mutual funds, are you diversified? Of course not. What if you own six different European funds or international funds? Same story. So what are these people doing when they split their money up between several different mutual funds? They're diversifying, but only enough to eliminate one risks; manager risk. For the most part, these investors are completely ignoring the other risks. Being one-fifth diversified is better than nothing, but not by much.

Most investors, and even some investment advisors, pay little more than lip service to the topic of diversification. Yet, if you buttonhole ten pension managers and ask them what the most important techniques behind managing a pension fund are, most likely, all ten will say asset allocation and diversification. The word "diversification" gets tossed around a lot. It appears in almost every TV show, interview or article about investing, but that's not enough to convince today's investors. If you want to reduce risk while improving returns, real diversification is a must. The only way to accomplish real diversification is to utilize all available asset classes in your portfolio.

In order to discuss diversification properly, I need to briefly touch on the different asset classes included in the investment portfolios of the great pension plans. These asset classes will be discussed in greater detail in the following chapter. For now, it's sufficient to discuss them in general terms. The five asset classes are:

-cash

-fixed-income (bonds, CDs, preferred shares)

-equity (stocks)

-real estate

-absolute return investments

Most investors grab a basketful of mutual funds or stocks and think they're diversified. The reason their portfolios aren't diversified is that they've only eliminated one of the five types of risk. If we want to reduce and eliminate all five types of risk, we need to use all five asset classes. Why do we need to use all five asset classes? Correlation. The five asset classes each have unique features. They each have their own advantages and disadvantages. Although they can all suffer from price volatility, they don't necessarily do it at the same time. In fact, the very conditions that may lead to a drop in the price of one asset class will generally lead to another asset class enjoying a gain in price. The relationship between the prices of the five asset classes can best be described using correlation.

Correlation, as it relates to investing, is a statistical technique, which shows how closely two assets are related. Perhaps the best example of correlation is height and weight. Taller people tend to be heavier than shorter people. The relationship between height and weight isn't perfect. I'm sure you can think of a shorter person who's heavier than a taller person you know. However, the more people you take into account, the more precise the relationship becomes. If you considered all the people who live in your city or town, you'd find that as the average height increased, so would the average weight. This type of correlation is called a positive correlation. You know that on average, as height increases, weight increases as well. Not all events are correlated. The number of people in your city or town who'll buy new cars this summer is completely unrelated to the number of days it'll snow this winter. It's also possible for two different things to have an opposite relationship; you'll recall that this is referred to as a negative correlation. In the case of negatively correlated assets, you could expect that one would go up in price, when the other went down in price, or vice versa.

The correlation between two assets is described by a scale that ranges from -1 to +1. Two assets with a correlation of 1.0 would be perfectly related; as one goes, so would go the other. Two assets with a correlation of 0.0 would be completely unrelated; the movement in price of one tells you nothing about what to expect from the other. Two assets with a correlation of -1.0 are negatively correlated; they'll always move exactly opposite to each other. The effect of any asset class on your portfolio can be quickly and accurately measured with the -1 to +1 correlation scale.

Having assets in your investment portfolio, with a strong positive correlation to each other, doesn't help to diversify it. This is the reason why an investor who owns a large number of equity mutual funds experiences high volatility in his or her portfolio. If some of that same investor's portfolio was in bonds, the volatility would be slightly lower, but because only two asset classes are being utilized, it would still be quite high overall. The same principle applies to a basket of stocks. If an investor has twenty or thirty individual stocks in her portfolio, she may think she's diversified, but since she's only using one asset class, she'll discover that the stocks she owns tends to move up and down with the market. The systematic risk has been diversified somewhat, but the effect of the other four risks will still tend to cause the portfolio to be very volatile.

In order to be properly diversified, a portion of the portfolio needs to be invested in each of the five asset classes.

What would happen to a properly diversified portfolio if the economy suddenly entered a sharp recession? As a general rule, the stock markets as a whole drop significantly during the early stages of a recession. Obviously, the equity portion of a diversified portfolio will drop. The correlation between equities and the stock market as a whole is very high. The cash portion, on the other hand, will be completely unaffected. There's virtually no correlation between cash and the broader stock markets. During a recession, the Federal Reserve will generally lower interest rates in order to help stimulate the economy. Lower interest rates are good for the bonds that a diversified portfolio holds. If the interest rate offered by new bonds is lower, then the value of the bonds already owned in the portfolio will go up proportionately.

The correlation between the declining equity markets and bond prices is generally negative. When stocks go down, bonds tend to go up. Real estate as an asset class also has a negative correlation to declining stock markets. Investment real estate provides a steady income stream; as interest rates drop, the value of this income stream increases.

But how would the fifth asset class, absolute return, react to a sharp recession? I realize there's a good chance that you don't know specifically what type of securities would qualify as part of the absolute return asset class, but for now, let's not worry about it. The only thing I'll say about this asset class now is that there's virtually no correlation between the behavior of the absolute return class and any other class. In other words, none of the many factors that affect the prices of the other four asset classes have any tangible effect on the absolute return class.

Think back to the last recession. The stock markets dropped quite a bit, didn't they? On average, the stock markets drop over thirty percent in a recession. What happened to your investment portfolio? I'd be willing to bet that it dropped as well. Now let's consider what would've happened to a properly diversified portfolio. As the recession started, the equities in the portfolio would've dropped, the cash and absolute return asset classes would've been unaffected by the market drop and you'd expect to see the fixed-income and real estate asset classes rise in value. In total, you have one asset class down in value, two unaffected and two rising in value. The properly diversified portfolio is going to ride out the stock market decline in relative comfort, and if you're the proud owner of a diversified portfolio, you're going to be riding in comfort and safety as well.

Let's try another example. What would happen to a diversified portfolio if we were to enter a period of high inflation? Well, for starters, fixed-income as an asset class is going to get hit hard. High inflation means high interest rates. The same bonds that made us a profit as interest rates dropped are now going to lose money as rates rise. The interest rate we're receiving on our cash will increase, so as an asset class, cash will do well. Equities will not do very well in a high interest rate environment. When investors can get high rates on bonds, they tend to sell their stocks and this pushes the prices down. The real estate asset class will be strong on the other hand; both the value of the properties owned and the income stream from them will tend to rise with inflation. The absolute return asset class will be completely unaffected.

How did our properly diversified portfolio make out in a high inflation environment? The final score was two asset classes down, one unaffected and two up. Note that I didn't say the absolute return asset class finishes even in this example, rather I said it's unaffected. It would still produce something like its expected return. Overall, the diversified portfolio should provide above-average returns in a high inflation environment. The undiversified investor, on the other hand, would be in for a very rough ride. What do most people you know have in their investment accounts? Equities and fixed income-the two very asset classes that were hurt the most. This is a very trying time for average investors. Remember the early '70s?

I think I'm making my point. War, recession, inflation, currency crisis, you name it, whatever the crisis of the day happens to be-parts of the properly diversified portfolio will shine and the ride will be smooth and comfortable. From the peak of the '90s bull market to the bottom of the subsequent bear, the broader stock markets dropped almost fifty percent in what amounts to the second-largest market decline of all time. It was devastating to many investors. How do you think the great pension plans did? I'm sure by now you know the answer. They did just fine. Millions of investors lost literally trillions of dollars in wealth, but the properly diversified portfolios were all right. Why do you suppose that is?

The answer is, of course, that out of the five asset classes, only one actually went down! Fixed-income and real estate posted great returns and, as you'd expect, the cash and absolute return asset classes were unaffected. One asset class down, two unaffected, two up-just a regular day at the office for a properly diversified portfolio.

Diversifying through the five asset classes lowers the risk and improves the consistency of an investment portfolio. When a portfolio posts consistent returns, there's no need or temptation to take undue risk. A less diversified portfolio will suffer from increased short-term volatility and can easily fluctuate to extremes. The problem with this is that what might seem to be a moderate and acceptable loss at the time will often require a huge gain to offset it. A vicious spiral can ensue, with investors feeling that they have no choice but to take even greater chances in order to make up for lost time.

Please allow me to provide an example. Say you have a less-than-diversified investment portfolio that's expected to return a reasonable ten percent per year. An underdiversified portfolio such as this is exposed to undue and often unwise risk. It would not be uncommon to occasionally see a year posting a loss of fifteen percent. What may surprise you is that in order to make up for the fifteen percent loss, your portfolio would require an astounding forty-two percent gain the following year.

A loss of only fifteen percent requires a gain of forty-two percent in order to get back on track! That's asking a lot. It's not hard to see how some investors are tempted to take unwise chances in their haste to recover losses. On average, the stock market suffers a decline of greater than thirty percent about every five years. The larger the loss, the more difficult it is to recover from. A twenty- five percent decline would require an astronomical sixty-one percent return the following year in order to get back on track. There's simply no way to even attempt to receive a sixty-one percent return that doesn't involve a ton of risk. Taking undue risk inevitably leads to significant losses. Following these inevitable losses, the investor is faced with a choice: they can either accept the permanent setback or attempt to recoup these losses by undertaking more, even higher risks. Ultimately the choice doesn't matter, because this is a train to nowhere-you lose either way. It's time to get off and diversification town is the only winning stop.