Diversification

We have all heard people talk about diversified portfolios. I Believe diversification may be the most overused and misunderstood concept within the investing community. If you ask most people to define diversification they might explain the concept as “not putting all your eggs in one basket”. While this idea certainly begins to describe diversification, the question remains. How many baskets do you need? Which baskets should I use?
Professional portfolio managers deal with diversification every day while most individual investors face this dilemma when they are allocating assets in their 401k plan.
The “spread my assets over as many asset classes as I can” paradigm is the most widely understood idea and is only part of the equation. An elementary understanding of this valuable concept can mislead investors to make costly and counterproductive decisions. Let me give you another dimension to diversification.
Diversification might be the most familiar term to investors, but the most critical concept is correlation. Both diversification and correlation admittedly are theoretically related, but correlation explains why diversification works. Correlation explains how two investments are likely to react in a static market environment. By measuring the correlation of two investments, we can understand whether they tend to move in a similar direction or not.
An effectively diversified portfolio should contain a mix of holdings that tend to react differently in the same market environment. Instead of focusing on simply the number of holdings in a portfolio, we should shift our attention to how specific components work together.
Throughout my career I have been asked if a person should add a stock or fund to a portfolio. The first question we must answer is whether the addition provides any diversification benefit. Determining the existence of diversification benefit can be measured and or quantified.
When most people think of diversification, they immediately equate the term as requiring a certain number of elements. In essence, the implication is more means better. In fact, portfolios can become over diversified and any additional components can decrease the effectiveness of the portfolio mix.
I recently reviewed a case where a portfolio contained 18 asset classes and 41 sectors. Over time and for various reasons portfolios can pick up layers of needless exposure. Not only can the extra weight take away from a portfolio’s balance, but the embedded fees and other expenses can erode the performance of the portfolio over time.
Remember, it is not the number of holdings that hold the key to diversification, but how the holdings contribute to the efficiency of the entire portfolio that matters most. Strive for simple balance in your portfolio with less moving parts. I would rather own a portfolio that contained umbrellas and suntan lotion than one that contained 10 different brands of suntan lotion.

Learn from market sell offs

Sell offs in the market are never fun unless you are short the market. However we can learn valuable lessons from these events. On days where there is almost no place to hide in a sell off you may find asset classes which are traditionally non or negatively correlated moving in the same direction. This might tell you that the selling action is systemic in nature or that your portfolio is simply experiencing the effects of what we call the reversion to the mean. Look carefully in days of major market pullbacks and you might find some stocks that are actually flat or moving positive. Look at the data from today and discover if there are any stocks or ETFs that emerged from this fire as cool as can be. This crash test concept can be very helpful when you are ready to select new stocks to a portfolio. You might want to move holdings that are strong in sell off conditions like today to the top of your shopping list.