Diversification Is Underappreciated, Part II

There are many concentrations to avoid.

In the first part of this two-part series, I discussed how diversification is not meaningful until after we have defined the goals we are trying to achieve. Let me now explore a little nuance in the realm of diversification—from what are we diversifying?

Assume a stereotypical 60/40 investor who has 60% of his financial assets in stocks and 40% in bonds. He owns about 30 stocks and 10 different bonds. Suppose the stocks are “blue-chip” stocks, big and “safe” U.S. companies. Suppose the bonds are all investment-grade including some U.S. Treasuries. Is he diversified?

Well, again, we need to ask: compared to what?

Some famous investors might consider that he is diversified. Still others might differ. I would be among those arguing that he is very likely not properly diversified. First, I would want to clarify with some questions:

• What sectors and industries are the 30 stocks in?

• Same question for any corporate bonds.

• What style of stocks are in the portfolio (growth versus value)?

• What is the portfolio’s exposure to market volatility (e.g., beta)?

• What proportion does he have in each holding?

• What is his cost basis and thus potential tax liability in each security?¹

• What is the term structure of the bonds (i.e., average maturity and duration for each and in total)?

Answers to these questions could identify a lot of concentrations (i.e., lack of diversification) that still exist within the portfolio—compared to a similar market benchmark.

Second, I would suggest there are inherent weaknesses from a diversification standpoint that he is running outside of the portfolio—compared to a broader array of potential investments. In other words, even if we satisfy the first measure of diversification, he may still be concentrated.

It may strike you as odd, but diversification should be thought of as both more and less exposure. More in the sense that your investments are more broadly invested, and less in the sense that any particular exposure is relatively minimized.

Here are some considerations on what he probably lacks:

• Exposure to mid-sized and small-sized public companies

• Exposure to international companies and markets

• Exposure to non-dollar assets

• Exposure to municipal and high-yield bonds

• Exposure to public-market asset classes outside of stocks and bonds (e.g., real estate, industrial and monetary commodities, foreign currencies, derivatives, etc.)

• Exposure to private-market assets (e.g., private equity, private debt, hedge funds, etc.)

• Exposure to various risk-mitigation strategies (e.g., asset location and structuring, tax strategies, insurance strategies, etc.)

In the prior post I alluded to thinking of diversification by type rather than degree. This is what I’m getting at—rather than thinking about diversification simply as being along a single dimension of reduced volatility, et al., we should think about diversification as multifaceted. There are many types or ways to be diversified implying no simple solution.

By no means am I saying one should have exposure to all of the different assets and asset classes listed above. That is likely not prudent nor feasible. I am a strong opponent of private-market assets for almost all investors as these usually are not anywhere close to being justified on a risk-adjusted return basis. Most of the time assets outside of traditional stocks and bonds (or funds investing in such) also do not meet the risk/return test or are improper otherwise. The same can be said for insurance products like annuities and life insurance when used as a tool for investment.

Yet these second-order items are all important considerations and mostly (and most commonly) in the first few points raised. Having 30 “blue-chip” U.S. stocks might at best deliver diversification against a backdrop (benchmark) of the S&P 500.² Yet it would woefully lack diversification away from large U.S. companies. This lack of exposure would only matter when it matters—when U.S. large companies were behaving materially differently than small companies, international companies, etc. In this sense the investor is concentrated in large U.S. stocks.

Now for an investor who happened to have this concentration, the last 10 years have been great. But that gives away the game. He wasn’t trying to outperform non-large U.S. stocks IF he was trying to be fully diversified against those other asset classes. Should he have been tying to outperform? We don’t know: See Part I. Yet the point remains that the investor cannot simultaneously claim to have a level of complete diversification that extends across the entire stock market and somehow obtain returns that differ (good or bad) from that benchmark.

Very likely an investor wants meaningful diversification against non-market risks but not complete diversification as that is not feasibly possible³ and there are potential risk-adjusted gains (alpha) from sinning a little. The devil is in the detail of balancing all facets of diversification.

1. This has implications for rebalancing and trading otherwise. For example, if he has a very large gain in one stock and minimal in all others, the tax implications would be exerting undue constraint on his ability to manage the portfolio.

2. Don’t you dare bring up The Dow.

3. And some might say not any fun.