Diversification is one of the most often used and most often misunderstood concepts in investing. Investors are frequently advised to diversify their portfolios. Most people are rarely told what true portfolio diversification is, how to correctly construct a diversified portfolio or what to expect from the portfolio in terms of risk and rewards.
The idea of using a diversified investment portfolio is usually attributed to an article published by Prof. Harry Markowitz in the Journal of Finance in 1952. The article gave birth to what has been called “modern portfolio theory” (MPT). It is widely accepted but I think it fair to say most people who claim to understand MPT do not. If they did they would not invest as they do.
Markowitz was, first and foremost, a mathematician who applied mathematics to investment portfolios. The calculus that he used is not that complex if calculus is your thing but most people who swear by MPT cannot do the math themselves nor do they understand it.
The goal of MPT is not to get the highest return but to get an efficient return for the amount of risk that the investor is willing to assume. In a nutshell, Markowitz believed that by constructing a portfolio with a number of stocks, the winners will balance out the losers. Deciding upon which stocks to buy and how many has always been the vexing problem.
There have been a number of studies over the years that suggest the correct number of stocks to buy to gain diversification of the risk of a catastrophic loss is somewhere between 15 and 20. Some people believe that they should buy a much larger basket, such as an index fund that tracks the entire S&P 500.
The large basket, index fund approach is the result of the capital asset pricing model (CAPM) which suggests that maximum diversification comes from buying a pro rata share of all available assets. The CAPM was introduced by Prof. William Sharpe in 1970.
Both Markowitz and Sharpe are trying to solve the same problem, constructing a portfolio that efficiently deals with the risk of loss. Understanding the significant difference between the two approaches is where most people get lost.
Markowitz suggested that one way to mitigate the risk of investing was to create a portfolio that contained a mix of non-correlated assets. Non-correlated assets perform differently during periods when market conditions change.
A classic example of non-correlated assets might be an oil company and an airline. Oil company profits tend to rise when oil prices go up because the companies can get increased prices and margins. Airline company profits tend to fall when oil prices increase as their operating expenses increase. Oil prices and other commodity prices fluctuate up and down with supply and demand, weather, political decisions and other macro economic factors.
This economic see-saw is usually felt in the credit markets. Fixed income securities are generally safer than equities. Investors generally seek safer investments and like steady income. But investors will move out of fixed income securities and into equities when interest rates are low as they have been in recent years. Low interest rates often translate into higher profits for companies that borrow money pushing the price of their shares up.
That is why it is fairly easy to predict that people will begin to take the profits that they have made in equities in recent years and put their funds into fixed income securities as interest rates begin to rise. Remarkably, a lot of people who are in the business of asset allocation simply ignore that fact.
A great many portfolios, especially those prepared by robo-advisors, construct portfolios allocated between equities and fixed income securities based upon the investor’s age. They argue that younger people can assume the risk of investing more aggressively into equities. Neither Markowitz nor Sharpe ever considered an investor’s age as part of their analysis. The focus should not be on how old the investor is today, but what the markets are doing today and what do you anticipate that they will do in the near term.
Markowitz believed that portfolio construction should begin with observations and beliefs about the future performance of the available securities. That means that you should buy securities whose price you think will appreciate. You may be wrong due to market or other factors but if you are buying stocks that will react differently to those market factors you should not suffer catastrophic losses.
The CAPM on the other hand looks primarily at a stock’s volatility or beta. The beta is determined by how much more or less volatile a company’s stock is than a broader index. A stock whose volatility is the same as the index has a beta of 1. That is why people are encouraged to purchase an index or other large basket of stocks to get their portfolio’s beta closer to 1.
The essential difference between these two approaches is that Markowitz was looking at the fundamental factors that contributed to each company’s performance. This fundamental securities analysis looks at a company’s business, management, competition etc. and tries to determine if the company will be profitable in the future and if so, how profitable.
CAPM on the other hand, looks at the how the company’s shares have performed versus the index in the past. It is grounded in technical securities analysis which specifically looks at how a stock’s price has acted in the past and projects how that stock will trend into the future. Technical analysis looks at the market rather than the company. It suggests that everything that anyone would want to know about a company is reflected in the current price of its shares.
I learned basic technical analysis in the commodities markets years ago where most traders charted the markets which were governed more or less by supply and demand for the underlying commodity. I know many short term traders who swear by technical analysis but not so many who would use it to predict long term trends for investment. Past performance, after all, is never an indication of future performance.
I also take issue with the idea that everything that anyone would want to know about a company is reflected in its share price. I buy a stock it is because I believe that the price will appreciate. The person who is selling that stock to me generally believes that it will appreciate no further or else logic suggests that they would not sell it.
Neither approach is right or wrong. Both are trying to predict the future which will always be an imperfect science. Both Markowitz and Sharpe are Nobel Prize winners.
Over the years I would carefully research the companies in which I invested. I would read multiple research reports on each company, some positive, some negative, published by analysts whose opinions I came to trust. Research is a time consuming project. I now have an advisor who does this for me.
My advisor suggests that I only invest in companies thathave a history of paying regular dividends. That fact alone usually reduces volatility.
Robo investment advisors are firmly rooted in CAPM. They ignore fundamental facts about companies and markets. If you buy an index fund, then the results you will get will mirror whatever the market does. This is fine when the market is going up. I have continually advised anyone who would listen that robos are a bad idea and when the market turns down, which it eventually will, people who are in robos and who stay invested in robos will take losses that they should not have to take.