Portfolio Diversification: How to Avoid the Number 1 Mistake In InvestingJuly 12th, 2012 by David Waring
To make up a 50% loss on your portfolio, requires a gain of 100%. Let’s assume that you invest $100 and lose 50% of that $100 in the first year, leaving you with $50. The next year, you make 50%. However, a 50% gain on the $50 you now have in your portfolio, will increase to only $75, which is still a 25% loss of your initial investment. Not understanding this basic concept leads to the number 1 mistake in investing: focusing too much attention on trying to earn a profit, instead of first trying to avoid losses.
So how do you go about minimizing losses on your portfolio?
Bad Idea: Trying to Time the Market
While an investment may have a very attractive total return over a period of 10 or 30 years, your return may be very different depending on when you start and end the investment. In 2008, the stock market fell more than 40%. Had you invested in 2007 or needed to withdraw money in 2009, your returns would be far different than the historical average return for the stock market for the last 10 or 30 years. So why not try and predict when the market is going to crash?
No one knows when the market will crash! Every time there is a major market crash, there are always a few analysts and traders that get it right. In 1987, Abby Joseph Cohen at Goldman Sachs called the market crash. Twenty years later, it was Meredith Whitney that sounded the alarm. The market calls made by Cohen and Whitney afterward proved to be less prescient. In 2010, Whitney predicted hundreds of billions of dollars of municipal bond defaults that never materialized. Those that followed her advice missed out one of the biggest municipal bond bull markets in recent history. There is a famous saying that precedes both Cohen and Whitney, “Economists have predicted 10 out of the last 3 recessions!” The bottom line is that by trying to time the market you are not only unlikely to miss the major downswings in the market but you are also likely to miss the major upswings as well.
Good Idea: Minimize Portfolio Volatility Through Diversification
If you can minimize volatility, you decrease the chance that your returns will be far below market averages. As we discuss in our article “The 60/40 Rule of Investing” often times you can reduce the volatility and risk of your portfolio substantially without having to give up a significant amount of potential return in order to do so.
There are really only two ways you can decrease the volatility of portfolio:
- Combine many assets (potentially high volatility) that have low correlation with each other
- Add low volatility assets
Unfortunately, with bonds these two explanations often get confused or conflated together.
Combining Many Assets With Low Correlation
What is correlation? Its the tendency for two different assets to have price moves in common. For example, two assets with a correlation of 0.5 means that if one asset has a positive move, 50% of the time the other asset will move in a positive direction as well. It does not mean that if one asset moves $10, the other will move $5.
One metaphor for assets with high correlations would be a band. If the drummer does not set a good beat, its difficult for the rest of the band to play well. Conversely, a metaphor for low-correlated assets would be stand-up comedians. While they might appear one after another at a club, the influence that one will have over the others performance will be minimal.
“Modern Portfolio Theory” (yes, the theory is literally called modern portfolio theory or MPT) says that if you combine a few uncorrelated assets together in the right proportions, you can reduce the volatility of a portfolio even if they are by themselves high volatility. Using this theory as the intellectual background, many financial institutions suggest adding foreign bonds (emerging market and world bond funds) to one’s portfolio.
Adding Low Volatility Assets
Intuitively, it make sense that adding a low volatility asset will reduce a portfolio’s volatility. The ultimate low volatility asset is cash. Add a cash position to any investment portfolio and you will reduce that portfolio’s volatility. A 50% cash portfolio and 50% stock portfolio will have half the returns and half the volatility of an all stock portfolio. While cash is the lowest volatility asset, there are several low volatility assets. In particular, short-term, high-quality bonds are low volatility assets. Add these to any portfolio and you reduce volatility. While adding these bonds don’t provide as much volatility reduction as cash, they do provide more potential return than stocks.
As you move from shorter to longer maturity dates, you reduce a bond’s value as a volatility reduction tool. Similarly, as you move from bonds with higher credit ratings (like municipal bad treasury bonds) to bonds with lower credit ratings, you reduce a bond’s value as a way to reduce a portfolio’s volatility.
With this in mind, if you are looking to use bonds in order to reduce the volatility of a portfolio, you want to avoid any bond or bond fund with an average maturity over 6 years, and anything that invests in sub-investment grade bonds.
What’s the Bottom line?
Trying to minimize portfolio volatility by combining many assets with a low correlation is a complex process. Because of the complexity involved many times when people think they are adding an investment with a low correlation that will diversify their portfolio they actually are not.
As we have outlined above, trying to minimize portfolio volatility by adding low volatility assets is a relatively simple and straightforward process. It is therefore our recommendation that investors focus on minimizing portfolio volatility by adding low volatility assets like short to intermediate term bonds or bond funds, instead of trying to find low or uncorrelated assets.
For more on how to do this see our article on “The 60/40 rule of investing”.