'False' Diversification May Prove Costly In 2007

Discussion in 'Wall St. News' started by jackstone54, Apr 14, 2008.

  1. Thought I might cut and paste this article. This illustrates how bad conventional wisdom can be at times.


    'False' Diversification May Prove Costly In 2007
    by: Chris Ciovacco posted on: January 01, 2007 | about stocks: BOE / SPY / VBK / VGK / VO / VTV / VV Font Size: PrintEmail

    "Every great mistake has a halfway moment, a split second when it can be recalled and perhaps remedied"--Pearl S. Buck (1892-1973)

    The quote above is not meant to suggest that we need to prepare for gloom and doom in the new year, but to remind us that in 2007 the investment markets will not necessarily behave as they did in 2006. Bull markets have a tendency to make us forget about the benefits of true asset class diversification. Since we are now into year five of the current bull market in U.S. stocks, it may be a good time to take a moment and check on your portfolio's asset class correlations. It is not uncommon to find what I call "false" diversification in what appears to be a well-diversified portfolio.

    The Concept of “False” Diversification

    Let us assume we have a somewhat typical, well-intentioned investor who has a real job and a real life outside of the financial markets, which limits his or her ability or desire to follow the financial markets on a daily basis. This typical investor understands the need to be diversified or to “spread out” the risk in their investment portfolio.

    To illustrate the concept of “false” diversification, we will also assume that this investor has growth as their primary investment objective. This profile fits many investors between the ages of 20 and 55 (still at least 5 years from retirement). In a genuine attempt to diversify, our typical growth investor builds the following investment portfolio allocation giving them exposure to a wide variety of asset classes and management strategies:

    Table 1

    This investor may have a false sense of security thinking that they are diversified and therefore, protected against incurring significant losses in their portfolio. Below are the bear market returns with dividends reinvested for actual investments (either mutual funds or ETFs) that fit the investment allocation profile above. Mutual funds with a good performance record vs. their peers were used in order not to skew the results in a negative fashion. The investments below are listed in the same order as the allocation above.

    Table 2

    Figure 12

    For those of you who prefer ETFs, you could build a similar portfolio with false diversification using the S&P 500 ETF (SPY), Blackrock Core Bond Trust (BHK), Vanguard Large Cap ETF (VV), Vanguard Value ETF (VTV), Vanguard Mid Cap ETF (VO), Vanguard Small Cap Growth ETF (VBK), Blackrock Global Opportunism (BOE), and the Vanguard European ETF (VGK).

    It seems reasonable to believe that twelve different growth investments would offer some type of downside protection in a difficult period for U.S. stocks. If you are like many investors, the current bull market has lulled you into thinking that you are diversified. The “diversified” portfolio above would have declined by 42.29% during the bear market. During the same period, the S&P 500 declined by 46.01% (as measured by the dividend reinvested performance of the S&P 500 ETF).

    The fact that the investments above all declined when the S&P 500 declined and that they declined in similar magnitude tells you all these investments have a high positive correlation to the S&P 500. A high positive correlation means when the S&P 500 goes up, all the investments tend to go up and when the S&P 500 goes down, all the investments tend to go down. Now you can see why the term “false diversification” applies.

    Research shows that there may be a better way to build a portfolio of investments that offers “real” diversification and an opportunity for improved returns. In an effort to better prepare for 2007 and beyond, I recently conducted some extensive research on the potential benefits of investing in a wide array of asset classes, including some with low or negative correlations to U.S. stocks.

    Since the study, Protecting Your Wealth From Inflation And Investment Losses, is lengthy and somewhat tedious, I will attempt to summarize what the historical numbers tell us in future articles. While there are several ways to successfully approach the investment markets, I feel we can all gain some advantage from reviewing how different asset classes performed in both bull and bear markets. As time permits, I will continue to expand on these topics in the coming weeks.
  2. diversify = mediocre

    Buy a house, buy something in the market and be self employed. There is a diversification strategy. Your money is divided into three asset classes, real estate, equities, yourself. Invest proportionally over the years with whatever is obtaining you the best results. The end.
  3. fader


    i'd add the following to the asset clases listed above: bonds, cash and commodities. in addition to diversifying across asset classes, geographical diversification across some asset classes, such as real estate, interest rates and equities, is something to consider. i've read a paper recently on the subject that unfortunately correlations across asset classes are not stable over time, which makes the whole diversification exercise even more tricky.
  4. The article assumes that the investor placed all of their cash into the SPY (and other etfs) all at once and at the worst time.

    The best diversification strategy for the investor would be to diversify themselves equally through the etfs mentioned but dollar cost averaging during notable weak periods in the market versus the "all in" approach.

    However, instead of blindly investing during random intervals. I say the best strategy is to invest when the market is notably down at least 10% from the high of the year as determined by looking at a chart on a monthly basis. The summer months seem like the best time.

    I dont believe the investor would have been down by 40% had they been dollar cost averaging the entire time.

    However, how many investors would truly invest their cash into the market during a good scary correction. Most persons simply buy at the high and hope for the best.
  5. Excellent Commentary

    The Wall Street pundits investment premise that it is wise to keep some savings in stocks.....and when one listens to the likes of the head of Vanguard....which argues one cannot beat the market....then one would think that if one puts money into the SP500 index fund....then one is ok....

    Not true....

    It takes time to properly invest in the index....

    Since the are long time segments whereby the holders have not been rewarded....and since one cannot beat the market....or know the future.....then this suggests that one could devise a monthly dollar weighted program over a long period of time....

    The idea that one can just invest one lump sum in a single time segment reeks of just gambling....nothing more, nothing less....

    The odds are that literally no one has the patience to invest this way....and the brokerage community does not encourage this....because there are no mark ups in gradual dollar weighted indexing....
  6. thrunner


    Anyone reading the above piece should realize while the article is not bad, it is really just an advertisement for Ciavacco Capital :
    tauting the efficacy of his long-short hedging strategy, which is not specifically described in detail.

    This is not to be critical of this article in seekingalpha in particular, but rather in general, most authors of articles on seekingalpha has an agenda or commercial interest or position in the subject that they are writing about.
  7. This is not to be critical of this article in seekingalpha in particular, but rather in general, most authors of articles on seekingalpha has an agenda or commercial interest or position in the subject that they are writing about.


    I've come to the same conclusion.
  8. how about this: correlation is a terrible measure of risk. Correlation is not fixed, and does not prove any causal relationship.

    I think for a young person, stomach as much volatility as you can. Loss aversion allows for a non-linear relationship between volatility and returns. That's why small caps have destroyed the average return of the S&P over time, despite only slightly greater volatility.

    Instead, observe the major event risk, or a 5 sigma risk-make sure you will never suffer a total loss of capital or margin call under such a dynamic simulation.
  9. on the surface diversification seems like something rather simple to understand. in practice, effective diversification is much harder to accomplish. when crap hits the fan, many asset classes drop as risk tolerance is adjusted.

    diversification needs to be done in accordance to timeframe and the type of risks involved with the asset class.

    longer time horizon for the investor, the greater variance in returns they can eat. the key is understanding market conditions and making adjustments to protect the nest egg.

    over the past year for a US investor to truly diversify properly they would need to buy assets that would protect against the US dollar declining. foreign bonds and commodities would have provided this.
  10. ^yep....nominal share price volatility is only one risk factor...and it's not even properly measured with typical Gaussian metrics...

    1. Liquidity risk
    2. Systemic risk
    3. Currency Risk
    4. Credit risk
    5. Interest rate risk
    6. Political Risk
    #10     Apr 14, 2008