Diversification, Diversification, Diversification

In their well-known and oft-quoted 1986 study of 91 large pension plans, “Determinants of Portfolio Performance,” published in the Financial Analysts Journal, Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower found 94% of portfolio returns were determined by the asset allocation plan and just 6% attributable to market timing and security selection. Interestingly, however, most individual investors spend little time constructing an appropriate asset allocation plan. Rather than determining the ideal percentage to invest in stocks, bonds, and cash and spreading assets among various sub asset classes, most investors look for the hot stock. This return chasing results in portfolios that are overly concentrated in specific stocks or funds, which increases overall risk.

In Are stocks a loser's bet? another industry influential, William J. Bernstein, quotes research from Dimensional Fund Advisors that found that from 1980 to 2008, the top-performing 25% of stocks were responsible for all the gains in the broad market, as represented by the University of Chicago's Center for Research in Security Prices (CRSP) database of the U.S. total stock market.  So why not invest in only those carefully chosen "superstocks?"  Bernstein’s answer, “Simple: Because a portfolio of 'carefully chosen' equities could easily wind up with none of the best-performing stocks in the market - and thus produce flat or negative returns over many years. Missing out on even a handful of superstocks can leave you short of your target.”

Bernstein notes further that if you missed out entirely on the top 10% performers from 1980 to 2008, you would have cut your annual returns to 6.6% from 10.4%. How does translate into dollars? Bernstein says, “A $100,000 investment in 1980 would have grown to $1.8 million by 2008 at 10.4%. That same amount, at 6.6%, would have grown to only $640,000.” That’s quite a difference.

Here’s the bottom line: It is not worth risking your family’s financial security by speculating on a few stocks, no matter how carefully chose or how much inside insight you think you have. Think of your mother’s advice. “Don’t put all your eggs in one basket.” Spreading your money between stocks, bonds, and cash--asset classes that historically have responded differently to market conditions--is your best defense against being hurt by poor performance in any one asset class. As you see from the Callan Periodic Table of Investment Returns, one asset class never stays at the top or bottom forever. History teaches us that, like a seesaw, as some investments decline, others rise to offset those losses.

Our clients don’t expect us to help them outperform the stock market. Rather, they want our help to develop a plan pay for college, or maintain their lifestyle in retirement, or achieve other important goals. The best way to do this is to invest each client's money in a globally diversified portfolio based upon their goals and risk tolerance.  This does not mean they will never have losses but it is the best way to ensure they get the market return rather than hoping someone can identify the year’s top stocks for their portfolios.

Time to Re-assess Market Risks/Rewards?

According to Jim Parker, Vice President, DFA Australia Limited, understanding investment risk begins with accepting that “the market itself has already done a lot of the worrying for you.” As Parker notes, “Markets are highly competitive, which means that new information is quickly built into prices. Instead of trying to second guess the market, you work with it and take the rewards that are on offer.”

To put yourself in the best position to “take the rewards,” it’s wise to work with an advisor to build a diversified portfolio designed to meet your long-term goals – and meet periodically to review your progress and make necessary changes to ensure you are still on course.

If the Great Recession has altered your perception of risk, now may be a good time to meet to re-assess your risk tolerance. Remember, how much risk you decide to take involves assessing three inter-related factors: your future goals; your age and investment time horizon; and additional personal factors such as your current net worth and natural temperament.

As you consider where you fit in the risk spectrum, remind yourself of the Catch 22 inherent in the risk and return equation. That is, while Merriam-Webster’s Collegiate Dictionary defines risk as “possible loss or injury,” risk also is present in opportunities that will be lost if you totally avoid risk. The simple truth, according to Parker, is: “If there were no risk, there would be no return.” Your chances of getting the balance just right are much greater if you work with a financial advisor who combines what Parker refers to as the “accumulated knowledge of financial science” with in-depth knowledge about you.

Mother Knows Best: Don’t Put All Your Eggs in One Basket

We probably all can recall hearing our mother say, “Don’t put all your eggs in one basket.”  That solid advice to diversify is often misapplied to the investing front. Some investors think that buying 50 blue chip stocks complies with that adage. Others figure that buying ten mutual funds properly diversifies their portfolio, only to find that those ten mutual funds invest in many of the same stocks. Still others think hiring multiple advisors will ensure a truly diversified portfolio, but soon discover that those advisors use similar funds and that the management fees are higher than they would be with just one advisor.  So what does not putting all of your eggs in one basket mean?

True diversification means owning all of the stocks that make up the market, and it is the only true way to ensure you get market returns.  Further, spreading your money between stocks, bonds, and cash--asset classes that historically have responded differently to market conditions--is your best defense against being hurt by poor performance in any one asset class. History teaches us that, like a seesaw, as some investments decline, others rise to offset those losses. Additionally, you should diversify within asset categories by sub-asset class, even by investment style. Note, too, that diversification in any asset category is achieved more effectively through asset class mutual funds rather than with individual stocks. Building a diversified portfolio requires identifying your asset allocation strategy, diversifying within each asset class, and then periodically rebalancing your portfolio.

In honor of Mother’s Day, think back to what your mother told you about life: Be patient. Do your best. Look before you leap. Remarkably, her words of wisdom have a direct application in today’s markets.