Diversification is one of those terms that sounds simple enough but can be used in numerous different contexts and have a variety of meanings. In the world of investing, diversification means spreading your money around to reduce risk. Put a little more scientifically, it means holding assets that have very low correlation with each other.
So, to diversify, you open an account at Charles Schwab, another at TD Ameritrade, still another at Fidelity. Then give some of your money to an advisor to see what he or she can do. At Schwab, TD and Fidelity, you pick from a menu of mutual funds or maybe a few stocks. The advisor puts your money in one or two funds or buys some stocks. Done, right? Maybe maybe not…
How many of the mutual funds that you purchased hold the exact same stocks? Or, how many of your newly acquired mutual funds overlap one another in size or style because they hold many of the same stocks? What we see more often than not as Wealth Managers when analyzing a potential clients’ investment portfolio, is tremendous overlap in holdings or, a lack of diversification.
You have probably seen the traditional Investment Style Box online or in a mutual fund report. Professors Ken French and Gene Fama developed what is known as the 3-Factor Model in which they describe what that most impacts the returns of a stock portfolio. In addition to general market risk, a factor in determining the returns of a stock portfolio described in the Capital Asset Pricing Model (CAPM) developed by William Sharpe, Fama and French concluded, after studying thousands of portfolios, that the market capitalization (size) of a stock and its book to market ratio (value or growth) are two additional factors that determine the returns of equity portfolios. Size is easy to understand. Stock market returns of big companies are impacted differently by external factors than are little ones. For the most part, the Great Recession notwithstanding, the big companies are here to stay. Little companies come and go and, hence, are riskier. The book to market ratio determines whether a company is a growth or value stock. Growth companies have lower stock prices compared to their book value (balance sheet) and Value companies have higher stock prices compared to their book value.
The Fama French model below illustrates that by adding more Small and Value stocks (risk) to a portfolio, one may expect higher returns. However, adding more asset classes which are not closely correlated to one another (diversification)mitigates much of that increased risk without lowering expected returns. There is safety in numbers.
Diversification of stocks or mutual funds by name alone does nothing. Most mutual funds hold stocks that would plot all around Drs. French & Fama’s chart. They are diluted. One must read the fine print (prospectus) to determine what stocks a mutual fund holds. Real diversification comes with large numbers – numbers of stocks in a particular fund AND numbers of funds that have low correlation to one another. Confusing?
Take a look at the sample portfolio of ten mutual funds (Asset Classes) from a large institutional mutual fund company to the right. Collectively, it holds some 12,000 – 14,000 stocks and bonds from countries all across the globe. Note the specific descriptions of each fund. There is no ambiguity about the sort of stocks (US, International, Emerging Markets, Small, Large, Value Growth, etc.) that each fund holds. You won’t find IBM stock in the US Small Value fund and you won’t find Zynga in the US Large fund. For these funds to have low correlation to each other, they must hold only stocks representing exactly what their names indicate. They are as pure as possible. Now note the exposure to Small and Value. Four of the funds have Small (or Micro) stocks and five of them have a Value tilt! Emerging Markets add risk and higher expected returns. To offset additional risk, bonds may be incorporated. In this sample, the green slice representing 20% of the total portfolio is a fund that holds short-term bonds from all around the world. One may decrease risk by adding more bonds while maintaining the same mutual funds in proportionately lower percentages.
I believe that a globally diversified portfolio of mutual funds, with strict guidelines about what each fund may hold, offers the long-term investor the best opportunity for a successful outcome. Given the finite number of stocks in the world, there are only so many that a fund manager can buy within each category. This fact lends itself to the concept of buy and hold or, passive management. If you throw this all in a blender, it comes out as “Modern Portfolio Theory” which is a Nobel Prize winning body of research, and, a great topic for an upcoming edition of Wealth Extractions.