Most clients correctly understand that diversification among investments can decrease the risk of a portfolio. When most people think about diversification, however, they associate it with minimizing the volatility of a portfolio for a given level of returns. Diversification is arguably more important, however, for reducing the “value at risk” of a portfolio – the risk of permanently losing capital – rather than reducing volatility.

Limiting volatility is very important for clients who, understandably, do not feel comfortable seeing the value of their investments decrease over a short period of time. We all need to sleep at night, and highly volatile returns certainly do not help most people get their rest.

Permanently losing capital, however, constitutes a different, more concerning, level of risk. Whereas some people
are willing to sacrifice consistency for higher returns, no one, in their right mind, is comfortable irreparably harming their savings.

Diversification needs to focus not merely on limiting volatility to a range within which the investor can feel comfortable, but, more importantly, limiting the likelihood of some extreme negative event which can irrevocably harm a portfolio and its beneficiaries.

Asset Class Diversification

Diversification requires much more than just holding a large number of investments in a portfolio. In order to benefit from diversification – lowering volatility and decreasing the chance of permanently losing money, for a given investment return – investors should diversify across asset classes.

Common asset classes include: large-cap equities, real estate, investment-grade bonds, market-neutral hedge funds, private equity, distressed debt and many others, including domestic and international versions of each. Although investments within asset classes tend to correlate highly with one another, investments among asset classes tend to have lower correlations.2

This relationship (correlation) among the investments is what determines the riskiness of a portfolio for a given level of return. For example, if the stock market takes a turn for the worse, it is useful to have an investment which will increase in value in such a situation and offset the losses on the rest of a portfolio. Over time, investors who are properly diversified receive what is often called “the only free lunch in finance” – a higher level of returns for a given amount of risk.

Most people have exposure to too few asset classes and are missing out on this free lunch. For example, the traditional 60% equity 40% bond portfolio diversifies across only two asset classes.

Moreover, there is often an overlap between the equity and bonds in the portfolio, which happens when both the equity and the bonds are in the same type of companies (i.e. large-cap North American). This overlap mitigates the benefits of diversifying because the two asset classes will react similarly as events unfold.

For this reason, most institutional investors have moved away from the traditional allocation over the past two decades by investing in alternative asset classes such as hedge funds, private equity, real estate, infrastructure and distressed securities. Private investors who are able to do the same would be well served to do so.

Preparing for the Unprecedented

Individuals were often told by their investment advisors during The Great Recession that extreme negative returns were acceptable because “the events of the time were unforeseeable”. The whole point of diversification, however, is that investors should be protected from the unforeseeable.

History is constantly unfolding in ways which are new and filled with uncertainty. One of the most important investing maxims is therefore: the one thing we know for sure is that we do not know what the future will bring. An investment advisor should understand that the future can bring with it unprecedented and unforeseeable events. Only with this understanding in mind can he or she craft a well-armored, properly diversified portfolio.

It was the lack of proper diversification across the investment gamut, combined with the financial leverage employed by managers too sure of their expected returns, that led to such extensive financial losses between 2006 and 2009. Many investment managers modeled their portfolios based on historical information, and were not prepared for the unprecedented. Many of them did not institute sufficient safeguards in their portfolios, and suffered tremendous losses because of the unforeseeable.

Good investors must always approach their process with wariness and humility, expecting the unexpected and preparing for worst-case scenarios.

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