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Posted on May 30, 2017

The Importance of Portfolio Diversification

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Published by Don Hagan, CFA

The famous stock market axiom, “it’s the bus you don’t see that hits you”, nicely underpins the reasons behind maintaining a diversified portfolio.

The stark reality of investing is that there are unknowable landmines. Even though investment managers and analysts spend hundreds of hours scouring financial reports, talking to management, interviewing competitors and digging deep into a company’s prospects, there is always the possibility of an unpleasant surprise.

Consider two of the more famous surprises: Enron and WorldCom. At their peaks, both companies were universally rated “Strong Buy” by the analyst community and were loved by investors as the stocks raced higher. The Enron group even duped accounting giant Arthur Anderson, eventually causing their demise. By the time the dust settled with both companies, almost $200 billion of investor wealth was wiped out. Even the government-sponsored entity Fannie Mae “misstated” their financial statements from 1998 through 2004—ultimately causing billions in investor losses.

In each of the cases, analysts had time to review many quarters of financial reports. Why didn’t they uncover the deception? Because they were frauds—the managements’ misdeeds were done deep within each company and in a manner not necessarily decipherable from publically available information.

So then, how does one combat the unknowable? By diversifying away the risk. By not over-concentrating in one company, investors reduce their risk of potential one-off and company-specific disappointments.

The same holds true not just for a portfolio of individual stocks, but for the potentially more powerful concept of diversifying away risk by developing an investment allocation using different manager strategies and targeted asset classes.

This concept suggests that while holding a diversified portfolio of stocks makes sense from a risk-reduction standpoint, it is also valuable to utilize investment managers that employ different asset classes and methods of portfolio selection and management techniques.

For example, consider the hypothetical results of employing one U.S. stock-only investment manager versus three other equally weighted managers: one who specializes in bonds, one in international stocks and one in U.S. stocks.

For the U.S. stock manager, we’ll use the S&P 500 Total Return as the proxy. For the other three managers, we’ll use the Barclays Capital U.S. Long Treasury Total Return Index (Bond Index), the MSCI EAFE Total Return Index (International Stock Index) and the S&P 500 Total Return.

In 2008, the S&P 500 was down -37.0%. The Bond Index was up +24.0%, the International Stock Index was down -40.3% and U.S. stocks were down -37.0%. Together, the diversified portfolio was down -17.8%, versus just a portfolio of U.S. stocks, down -37.0%.

In 2009, the S&P 500 was up 26.5%, while the Bond Index was down -12.9%, and International Stocks were up 24.7%. Together the diversified portfolio was up +21.4%, versus the S&P 500 up 26.5%.

Here is what is interesting about this exercise: at the end of the two-year period, the S&P 500 was still down -20.3%. But the diversified portfolio was nearly back to even, down just -0.21%. By effectively diversifying targeted asset classes, an investor was able to reduce volatility and downside risk.

At Carson Institutional Alliance, we utilize many historically proven approaches to diversification and risk management when constructing your investment allocations. We have time-tested portfolios that utilize hedging techniques, others that employ cash, as well as different approaches to calculating stock valuations. We have strategies that focus on small cap stocks, while others emphasize dividends, international investments, downside protection, specific sectors, fixed income or income generation.

As you can see, we fully subscribe to the belief that diversification makes sense when constructing individual portfolios and an appropriate, individualized asset allocation.

At the end of the day, our goal is to develop an allocation that fits your needs and provides the diversification necessary to account for any surprise that may come.