Diversification

IS THE ONLY PROVEN WAY TO REDUCE RISK WITHOUT SACRIFICING LONG TERM RETURNS.  It’s obvious.  Own one stock or bond and a single event can change your net worth in seconds.  Own a couple dozen diversified by industry and a single event has much less impact.  True, a single positive event will also have less impact, but let’s face it, there is no free lunch. 

Of course fortunes have been made by making highly concentrated bets. Bezos, Gates and Zuckerberg owe their wealth to the phenomenal performance of just one stock.  Andrew Carnegie of U.S. Steele coined the phrase still repeated today to justify concentrated investing; “Put all your eggs in one basket and then watch that basket.”  That is the opposite of diversification.  So what’s all the fuss about?

The problem with concentrated bets is that for every Bezos or Carnegie that succeeded, there’s a much longer list of those who put all their chips on one roll of the dice and lost. This is called “survivorship bias”.  History tends to only remember the good outcomes. 

A better role model for investors is the Warren Buffett of today, whose Berkshire Hathaway now represents a massive portfolio of companies in nearly every industry.  Berkshire is never among the top performing stocks in any given year, but has a long term record that has made thousands of millionaires and Buffet one of the richest people in the world.  

It sounds simple.  Buy a well-diversified portfolio of different assets and you’ll do just fine.  But as the number of available mutual funds, ETFs, and private investments grow, the concept of diversification is being perverted in a way that detracts from long-term returns.  When diversification becomes its own goal rather than the means to an end, something is wrong.  The warning signs are higher fees, overly complicated investments and consistently poor performance. 

DIVERSIFICATION THROUGH ASSET ALLOCATION

The first step in asset class diversification is making an allocation between liquid investments, relatively stable income producing assets and riskier positions for growth.  This is your most important investment decision and you should make it based on your needs and risk tolerance, not the advisor’s opinions.

Historically this meant a combination of cash, bonds, and stocks.  Cash is a terrible investment, but provides for day to day spending needs.  Short term bonds generally provide stability and higher yields.   Long term bonds are a bet on falling interest rates.  Best case they provide both income and appreciation, but they can be as risky as stocks when rates spike.  Equities provide income with rising dividends but their main appeal is growth.  They are the best performing asset over any reasonable period of time but come with greater short term volatility.  That is why the prudent investor uses a combination to provide the desired amount of liquidity, income and growth.

We can then figure out how much you need liquid and keep it in money markets or T-bills.  If you have a long term goal of maximum growth, put the rest in stocks.  If you can’t handle the volatility of a stock portfolio, put enough in bonds to limit your risk.

DIVERSIFICATION AS A SALES TOOL

Not content to leave good enough alone, Wall Street invented a whole range of products that claim to improve diversification by investing in other asset classes; some real, some phony, some new, some well-known, some correlated to stock and bond returns, some uncorrelated. 

We have no problem with hedge funds, trading schemes, real estate partnerships or precious metals if they are sold on their own merits.  But the fact is, that most of these alternative assets are sold based on the faulty logic that putting a risky, expensive and poorly performing asset in a portfolio improves the portfolio.  That’s just nonsense!

We know a great deal about the way stocks, bonds and cash have performed for the past century and it hasn’t changed much recently.  When we get into most of what is being sold as an alternate or uncorrelated asset class we are generally dealing with unproven claims over short periods of time highly dependent on the success or failure of a single strategy.  

It is appealing to think that an asset allocation can be devised which will give the appreciation and income of a stock and bond portfolio with less risk by using other asset classes and new strategies.  Some investors will be lucky enough to get that, at least in the short run, but the vast majority will find that they have fallen for an expensive sales pitch which has performed well below what they could have gotten by sticking to the basics.

Ironically, most of these portfolios full of overpriced, untested products are sold by financial planners who used off the shelf software that purports to project your returns for decades in the future using historic performance of indices…then they try to “improve” that performance by giving you a portfolio that looks nothing like the indices.  They sold you on butter and they gave you snake oil.

DIVERSIFICATION CAN BE EXPENSIVE

Diversification for the purpose of low correlation can not only hurt returns, but it can be expensive! For example, one of the largest managed futures funds, AMFAX, returned 1.77% since inception in 2010 after subtracting its 1.75% fee.  The fund outperformed stocks once in 2014, but otherwise underperformed by ~10% per year. Was it worth owning the fund for one of year of outperformance? 

Finance hasn’t created anything new and original in generations.  New theories and products rarely, if ever, live up to expectations.  Instead of trying to time the market through asset allocation or enhance returns through newly created asset classes, the goal is to get as much of the potential from stocks as possible.  To do so you keep costs low and have an allocation that allows for long-term investing. 

INTERNATIONAL DIVERSIFICATION

We are often asked about our international investments.  It’s a fair question.  In a global economy are our portfolios diversified without international stocks?  With the click of a button we could purchase any variety of countries.  However, it’s easy to forget that when you buy an index it is made up of actual companies expected to drive returns. 

There was a big push in recent years to buy Europe.  Analysts showed this chart of performance since the Great Recession as evidence that Europe had to catch up. Not so fast!

The largest companies in the MSCI Europe index are Nestle, Novartis, Roche, HSBC, Shell, BP, Total, SAP, and Sanofi.   In other words buying Europe means big pharma, consumer packaged goods, and big oil…Three of the most uninviting areas for growth.  Diversification? If you count country headquarters as diversification, but these companies sell into the same markets as Pepsi, Pfizer, and Exxon so what’s the difference?  To get European exposure you’d need an index of companies that sell a majority of their products in Europe.  Even if it existed, the companies in it probably aren’t worth owning otherwise they’d be servicing global markets!

Emerging markets are another popular choice for diversification given that growth opportunities are better in the developing world. But is buying a fund of the large companies in India, China, and Brazil a good investment?  Unfortunately, when you look under the hood it consists of many companies with a history of poor track records, accounting disclosures, and governance. 

That doesn’t mean you should ignore international growth.  We just think there’s a better way to access it.  About 45% of the S&P 500 companies’ revenue comes from overseas.  Within the S&P there are companies like Abbott Labs who generate 65% from international markets.  It’s the CEO of Abbott Labs job to sell baby food in China or generic pharmaceuticals in India.  Instead of guessing if the Chinese or Indian stock markets are “cheap”, why not defer that responsibility to somebody who has a proven record of selling products into new and growing markets?

It’s not that we are against owning foreign companies.  We own a number of them for our clients, but we do so because we think they are good investments in high quality companies with growth potential, not just for the purposes of diversification. 

THE HIDDEN CONCENTRATION IN DIVERSIFICATION

Another conundrum behind the drive for diversification is that as you add it to your portfolio, it’s possible to actually increase your concentration.  Let’s say you buy the MSCI World Index for international diversification.  The fund’s largest holdings are Apple, Microsoft, Amazon, Facebook, J&J, Google, and JPMorgan.  Chances are you also own an S&P 500, technology, and growth fund.  Somehow while seeking diversification you unexpectedly emphasized a small subset of large-cap technology companies.  This is quite a common theme in mutual fund and ETF investing, where diversification is much lower than the multi-colored pie chart shows.

HOW COMPASS DIVERSIFIES PORTFOLIOS

Diversification is at the core of our investment philosophy.  We use diversified portfolios to minimize single stock and bond risk while still giving our clients the opportunity to enjoy a market rate of return.  Our hope is that by minimizing exposure to manias, we can do a little bit better than the market over time, but of course there is no guarantee. Every so often we hit a home run but occasionally there are strike outs.  Rather than put our clients at risk with concentrated portfolios we diversify.

80% of what we do is based on the market.  Only about 20% is individual stock selection.  The reason for this is simple.  Everything we know about the long term superior return of equities over other assets is based on the market indices.  It would be the height of duplicity  to sell our services based on the return of the market, but then give our clients a portfolio that looked nothing like it by concentrating on the on or two sectors that we thought would outperform the averages.

So we start out with portfolios that mimic the long term sector allocation of the market.  That may deviate from the current sector allocation of the market for two reasons.  One, there are times when the market itself is over concentrated in one sector because it has been favored for long period of time.   We try to limit our risk by keeping our allocation to a hot sector nearer to its historic average. 

On the other hand, some sectors may have had a long period of underperformance causing them to represent much less of the index than they have historically.   As value oriented contrarian investors we look to buy more of what is historically cheap.

The other 20% equity returns comes from stock selection, which we will admit is an art not a science and a difficult business in the best of times.   Our saving grace is that we are not trying to hit home runs in selecting stocks, we just want to find good companies at reasonable prices that we hope to hold for decades, if not generations.   It’s harder than it sounds, but a lot less risky than trying to pick the next company to revolutionize an industry or beat earnings expectations next quarter. 

REAL DIVERSIFICATION

Real diversification is selecting a combination of cash stocks and bonds that is appropriate for your needs.   It changes only when your circumstances change, not on when markets blow hot or cold.  Real diversification starts with portfolios that reflect the overall market but are customized for your income needs, risk aversion or preference for growth.  The result is a portfolio that is never the best performing in any one year, but is an all-weather vehicle for liquidity, income and wealth creation.

_{Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.}