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From Our CIO | One Second Grader with a Megaphone

by: Rick Wedell
published: November, 14th 2017


 

 One Second Grader with a Megaphone…

Written by Rick Wedell

Diversification is one of the most commonly used terms in personal finance. The need to have a “well diversified” portfolio is a mantra that is repeated over and over and over again! That said, few people understand what diversification actually means, and what they should do with their own investment accounts. So here you go - a little primer on what diversification actually is, why it’s important, and how to think about using it in your portfolio.

Diversification is about smoothing the up and down swings or “volatility”.  Imagine two second grade classrooms. One has twenty children, and the other has one child (we’ll call her Emily) with a megaphone that makes her twenty times louder than she normally is.

At peak volume, when all the kids are screaming, the noise level in both classrooms is the same. Ditto for when everyone is silent. If we assume for a moment every   second grader talks for the same amount of time in a given day[1], then the average amount of noise in each class over the course of a day is also the same.

BUT, the two classes can have much different experiences on their way to that same average noise level. Emily’s class is deafeningly loud or eerily silent at all times, and there is no in-between. In contrast, the other classroom sounds a little more like a crowded restaurant – at any given time, some children are talking while some are not so that the overall volume of noise remains pretty constant. Emily’s classroom noise is more volatile, despite the fact that over the course of the day the average amount of noise is the same.

In finance, we would say that Emily’s classroom is non-diversified when compared to the other. As a result, it swings violently from quiet to loud, versus the somewhat more predictable journey in the class with twenty kids.

The volatility in noise level may bother Emily’s teacher in the same way that volatility in a portfolio might bother the account holder. While both the diversified and the non-diversified accounts have a similar expected return (similar average noise), the non-diversified portfolio has much higher highs and lower lows, which investors can find disconcerting – many of us prefer a long smooth climb versus an erratic see saw.

Diversification works best with not completely dependent or “non-correlated assets”.  If you were to describe this analogy to any elementary school teacher, they would tell you that the twenty-child classroom is HIGHLY unlikely to sound like the blissful hum of a crowded restaurant. Which brings us to the next frequently misunderstood concept in diversification, which is correlation.

Diversification works best with non-correlated assets. Our twenty second graders are likely to either all be quiet or all be loud at the same time. Story-time? All is calm. Puppy visible in the window of the classroom? Pandemonium. The students are highly correlated in their noise level. Contrast that to the diners in a restaurant – there are multiple different discussions happening, each with the normal ebbs and flows of conversation, which all somewhat balance each other out. Unless the waiter drops a tray of dishes, we’re unlikely to get total silence or deafening roars.

In finance speak, the restaurant is more diversified (and hence less volatile) than the classroom because the adults in the restaurant are non-correlated with one another. In the context of your portfolio, you get the most benefit of diversification when you have a fairly large number of investments that perform independently. Your technology stocks do well while your industrial stocks lag, international stocks are up while domestic equities are taking a breather, etc. That mix of performance generates a less volatile return profile, while not diversifying away the returns that you should receive from being invested in the market.

Note that, just like in the restaurant, we occasionally get something that causes all of the assets to perform similarly. Geopolitical uncertainty, economic growth, commodity price shocks, and interest rate movements are just a few such events. These are called market risks, and just like what happens when the waiter drops a tray, they are very difficult to diversify away from.[2] 

From a practical perspective, what all of this means is that if you really want to really know how diversified you are, you need to drill into the performance relationship between all of your many holdings.

True diversification of risk for your household needs to consider more than just your investment portfolio. Consider, briefly, the story of Watford, North Dakota. A small town in the oil patch, it watched its population quadruple from 2010 until 2015, fueled by the ever-increasing demand for workers to service the oil fields. These were high paying jobs, and real estate prices skyrocketed during that time. Developers couldn’t build properties fast enough to house the endless demand for workers.

Fast forward to 2016. Oil prices fell, and new drilling activity was non-existent. Average rental rates dropped by over 50% for the homes in the area. Home prices have fallen by a similar magnitude. The local economy is devastated.

From a diversification standpoint, regardless of what they may or may not have invested in, Watford residents were (and still are) exposed to oil. Even those that didn’t work in oil related fields – retailers, restaurateurs, real estate agents – they all had their livelihood inextricably linked to the commodity that drove the local economy.

Your investment portfolio should take into consideration your career, your geography, and the fundamentals of your home’s economy when you start to think about diversification. The residents of Watford are an extreme example, but their predicament is not as unique as you might think.

I hope that this overview of diversification has been helpful! The purpose of diversification is, to borrow a hackneyed phrase, to avoid putting all of your eggs in the same basket. If oil prices collapse, the dollar falls, or interest rates spike, you would prefer that to affect a portion of your portfolio (and not the entirety of it). Even better, you might like to have something that rallies when any of those things happen, so that the gains in one thing offset losses in another. A well-diversified portfolio should have something going wrong in it at all times.

If there is one thing that I would leave you with, it is that you cannot tell how well diversified you are simply by the number of holdings on your investment statement. You need careful analysis of your investment positions and how they related to one another – the factors that drive them to perform similarly and differently. A portfolio with fifty internet stocks may well be less diversified than a single mutual fund – you cannot know until you (or your advisor) does the work.

 

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[1] A decidedly questionable assumption

[2] A significant amount of economic research would suggest that you actually earn a return from taking these market risks, and not risks on each individual company you invest in, but that’s a topic for another paper.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. No strategy assumes success or protects against loss. Investing involves risk including loss of principal. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Rick Wedell is not affiliated with LPL Financial.

Investment advice offered through RFG Advisory Group, LLC., a Registered Investment Advisor. 

 

LPL Tracking # 1-666048

 

 

 

 

 

 


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