IronBridge Private Wealth

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diversification

The Secret Downsides of Diversification

As of March 2021, Amazon had over 12 million different non-book products for sale (if you count books, it’s more than 75 million). Having an incredibly diverse product set is a vital part of Amazon’s business strategy.

Investors are often told diversification is a critical part of their investment plan. But is it really?

Taking numbers from 2019, there are approximately 4,210 equity mutual funds. The average number of stocks in each fund is about 38 for a large cap fund, and about 50 for a mid-cap fund. A broad asset allocation based on mutual funds could potentially have an investor owning hundreds of different stocks.

What happened to your portfolio in March 2020? Did broad diversification pay off?

Diversification Doesn’t Limit Losses Like People Think

There’s a saying that diversification is the “only free lunch in finance”. The premise is that a diversified portfolio will contain assets that move in different directions during periods of market turmoil.

For example, growth stocks may struggle when value stocks are doing well, as we saw earlier this year. It goes from style to asset class, sector, capitalization, and geography – all potential sources of diversification. Building a diversified portfolio is supposed to reduce risk, which will potentially increase return.

In theory, all well and good.

But what happens when there is systemic risk, as we saw during the early days of the pandemic?

Diversification can’t hold back a tsunami. Granted, black swans like 2008 or the pandemic are fortunately rare. But what isn’t rare at all are market cycles. They are predictable and regular. As the market moves through different cycles, different risks and opportunities emerge.

The problem is that asset allocations built on the principle of diversification aren’t built handle changes in the market cycle. They don’t see risk or opportunities coming, and don’t effectively react to these cycle changes.

Worse and More of it: Diversification May Limit Gains

Adding non-correlated investments to your portfolio is supposed to lower risk and increase return – but you can have too many. The result is that the risk-return profile decreases – you take more risk and get less return.

It’s called “deworsification.”

Deworsification is caused by creating a portfolio in which too many assets are correlated with each other. It can be caused by investing in multiple funds that hold many stocks, as described above. It can also be the result of combining different strategies in a portfolio. Investors need to be aware of hidden sources of over-diversification, such as target-date funds held in a 401(k).

Adding an additional asset allocation in a brokerage account can result in a portfolio that is simply duplicating efforts.

The problem here is that the portfolio isn’t just vulnerable to systemic risk – it’s also missing out on potential gains. The fear of concentrating in any one position often means investors lose out on potential sources of alpha because their asset allocation doesn’t allow for building a position or letting it run.

Said another way, assets tend to not perform the same in up markets, but perform identically in bad ones.

So having too much diversification hurts returns in good times without providing much protection in bad times.

A Different Approach

An ideal portfolio would seek sources of alpha and would be sensitive to risk – but only when risk exists in the market.

Limiting positions when the market cycle is indicating positive signals means reducing return. And risk management that reacts to changes in the market by reducing exposure to riskier assets can both protect your portfolio, but also allows for cash to be redeployed when signals turn positive again.

Creating this kind of portfolio isn’t about investing in stocks according to a static asset allocation – it’s about having rules that take the emotion out of investing.

Successful investing means you own right exposure, in the right amount, during the right point in the cycle. And when necessary, going to cash.

The Bottom Line

Investors have many options now, and investing can be deceptively easy – until markets change.

The free lunch quote above is attributed to Harry Markowitz, who developed modern portfolio theory – in 1952. There might be a better way than relying on traditional methods of portfolio management that haven’t kept pace with the realities of our investment universe.

Eggs in How Many Baskets? Prioritizing Building Wealth While You Build Your Business

Don't have too many eggs in one basket when you're a business owner.

Employees of publicly traded companies are often granted company stock as part of the compensation package. From a portfolio management perspective, holding outsize amounts of stock in the same company that provides income can increase risk. If the business were to become wobbly, not only would the stock decrease in value, but the employee could also potentially find themselves out of a job. Employees who are granted stocks often mitigate this risk by selling some of the company stock and reinvesting it in other assets, to diversify growing wealth away from the source of income.

But what about when you own your business?

The situation becomes more complex. One strategy that’s often followed is to put everything except living expenses back into the business while you are growing it, and then sell part of the business or take on a strategic investor to help you begin to diversify elsewhere. Retirement planning is put on the back burner until the business has grown to a point where the business can be monetized.

We think there is a more thoughtful approach that may work for business owners.

The Key: Diversification

While it may seem like a good idea, relying solely on your business as your source of wealth can expose you to a lot more volatility than you think. Whether it’s saving for a rainy day, or longer-term goals like retirement, if all of your wealth is tied up in your business, your business dictates your moves. Creating and regularly adding to a separate investment portfolio may help diversify your assets.  And if you invest away from areas you are already exposed to in your business, it can be a powerful tool to help you smooth volatility across both your business and life.  For instance, if your business is vulnerable to cyclical sectors, you’ll want to create an investment portfolio that is defensive against those sectors. 

Retirement Savings Tax Advantages

There can be significant tax advantages to setting up the right kind of retirement plan for your business and ensuring that you set aside money to invest as close to the maximum as possible every year. While there are of course upfront fees and ongoing costs associated with formal retirement plans, they also allow you to save in a very tax-advantageous manner. Depending on your situation, a 401(k) plan and a cash balance plan are tools you can use to save and look towards a future income stream you can access without having to sell your business. They can also be a great way to attract and retain talented employees.

How About Timing?

When you’re putting everything back into your business with the idea that you’ll eventually fund your retirement by selling all or part of it, you’re essentially making two bets: That you’ll be able to sell when you are ready and not before, and that when you are ready the market for your business will be at a good point for an exit.  Having to liquidate early because you are no longer able to run the business, or having to sell when either the business is struggling or the market isn’t right, can limit the amount you realize. You only get to sell it once, and your retirement life will be dependent on what you realize. If you’ve planned for a source of retirement income away from your business, you’ll have more flexibility when it comes time to sell.

 The Bottom Line

Even as you’re building your business, it makes sense to think about your personal wealth as a completely different stream of future income. Thinking about diversification across your total asset profile can get you started on a journey to financial independence.

The information contained herein is intended to be used for educational purposes only and is not exhaustive.  Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return.  If applicable, historical discussions and/or opinions are not predictive of future events.  The content is presented in good faith and has been drawn from sources believed to be reliable.  The content is not intended to be legal, tax or financial advice.  Please consult a legal, tax or financial professional for information specific to your individual situation. This work is powered by Seven Group under the Terms of Service and may be a derivative of the original. More information can be found here.

Why We Believe in Active Management

A businessman holding a compass to navigate the business with marketing of icons and business growth graphs, Stock market and data exchange.

In 2019, the amount of money invested in passive funds in the United States surpassed that of active funds for the first time.1 Over the last decade, passive funds have increased assets under management to $11 trillion, from $2 trillion.2 Given the title of this piece, are we saying that all that money is in the wrong place?

Our issue isn’t necessarily with passive funds – we deploy some ETFs in our investment management strategies. Our issue is with the sea-change in portfolio management that the availability of low-cost index-tracking funds has brought about. It’s the prevailing idea that you can create an effective, all-weather asset management strategy by buying a bunch of different funds that represent different asset classes.

The Commodity Trend

Our foundational insight is to turn on its head the belief that asset management has become commoditized. We believe that for much of the asset management industry, investors are the commodity. Most advisors use a one-size-fits-all pie chart strategy. They do a little tweak for your age and how far you are from retirement, and their tools spit out a portfolio recommendation with a bunch of different funds in it. Their theory is that these magical beans funds are going to work together to lower risk and maximize return.

They believe this because they are using data mostly since the early 1980’s to support their recommendation. The problem, as we discussed recently in our “Inflation Waves” report, is that almost every asset class has risen since then.

So they are looking at data that does not include some major market cycles. Specifically the one that we believe we are entering into now…one of rising interest rates and rising inflation.

The words “broadly diversified” have become a mantra, used by large and small firms alike, recommending that investors should be in all asset classes at all times. And meanwhile, broad market indexes like the S&P 500 are only getting more concentrated. It’s hovering around 27% in the IT sector, as defined by GICSs. But if we include companies like Google, Amazon and Facebook, tech exposure is close to half of the index. So, what is that doing to asset allocations?

The notion that diversification is an investment strategy that can replace a disciplined, rules-based investment process is where we draw our line in the sand.

Market Cycles are King

An asset allocation based on age is going to bump up against the realities of the world. Economies and businesses have cycles. Add in the natural human behaviors of fear and greed and you have the market cycle.

And the market cycle doesn’t care how old you are.

If you are lowering your risk during a period when market cycle signals indicate risk is low already and the potential for return is high, you are leaving money on the table. And vice versa.

Diversification Doesn’t Manage Risk

We aren’t suggesting that risk management isn’t necessary…quite the contrary. We believe the management part is important. Volatile markets require a system to manage risk. Being 50 years old or five years away from retirement isn’t a system, it’s a statistic.

Unfortunately, diversification fails exactly when you need it to work. Data shows that asset correlations rise when volatility rises. This means that when markets undergo stress, most assets fall at the same time.

The reported benefits of diversification (having assets that perform differently during different periods) simply isn’t true. In fact, the opposite what happens in the real world.

Rules Are Good

So if passive investing is not the way to go, and broad diversification isn’t all that great, what can you do?

First, we must recognize that investing is inherently emotional. We spend a lot of time with our clients to ensure that their emotions will not impinge on their investment plans. The best thing a client can say to us is that they don’t worry about the money we manage for them, and we strive for that with every client. 

We do the same thing with the money we invest. We are tactical investors that follow a rules-based process in each of our portfolios. Simply put, we look at the underlying trends and momentum in the markets to determine good and bad environments. And then we make adjustments to our client portfolios, daily, weekly, monthly – whenever we identify either an opportunity to exploit or a risk to avoid.

That might mean we are broadly exposed to different asset classes; it might mean we are relatively concentrated in our exposures. We just don’t believe that identifying asset classes and then keeping exposure to them through every environment is a successful strategy.

The goal of our process is to participate in up markets and mitigate risk in down markets. Said a different way, our goal is to do more of what’s working and less of what’s not.

Passive management cannot do that. It can only allow you to participate in up markets while also participating fully in every down market.

Ultimately, a passive investment strategy works in up markets. But that is only part of the market cycle. When the down market comes, your (or your advisor’s) emotions take control. That’s when mistakes happen.

The answer is simply to develop, test and implement a rules-based process.

If you can prove a process works in different environments, and stick to that process, then you can have confidence that your system will work during all parts of the market cycle.

That is active management. And that is what we believe works.

  1. Lowery, Annie. Could Index Funds Be ‘Worse Than Marxism’? The Atlantic. April 5, 2021.
  2. Ibid.