Here's what everyone gets wrong about diversification

“Here is part of the tradeoff with diversification. You must be diversified enough to survive bad times or bad luck so that skill and good process can have the chance to pay off over the long term.” – Howard Marks

The markets have always acted crazy at times because people are emotional, but investors always seem to think that the most recent cycles have been more volatile than they were in the past. That’s not the case, but drawdowns are always more painful when you’re living through them in real-time.

It’s easy to look at historical charts in terms of losses and volatility because you know how it all turns out, but in real-time things are never certain. When time slows down investors can make mistakes because they panic and abandon any semblance of a plan. There’s a constant temptation to change your portfolio, plan or strategy because of something that just happened.

Remember the flash crash last summer that saw some fairly large dislocations in a number of securities and markets? In August of 2015 the S&P 500 fell 7% or so in just two days. Markets recovered fairly quickly but a few days later there were a number of stories praising a certain black swan fund:

Similarly, the Brexit panic saw the S&P 500 fall more than 5% in a couple days, with more carnage throughout the global markets. I’ve seen a number of stories showing the performance of various strategies over that time, including this one on risk parity:

 

Investors seem to be looking at the performance of portfolios, funds and strategies over shorter and shorter time frames to assess their desirability. Who cares how much money a fund made or lost in one day? All that matters is what investors did or didn’t do with those gains or losses and whether it materially impacted their long-term performance.

This isn’t so much a commentary on the merits of these two strategies, but rather a discussion about some of the misconceptions about diversification.

People are paying more and more attention to how certain strategies, asset classes or investments perform over shorter and shorter time frames. Investors are constantly looking for the best or worst performing sector/smart beta style/ETF/hedge fund/portfolio strategy during the latest two day or even two month sell-off or rebound.

That’s not how you build a long-lasting portfolio.

Since no one really knows how correlations will change and adapt in the future, it makes sense to build a portfolio with several different investment styles and strategies. But this idea can be taken too far when you try to account for every single potential risk that exists.

Yes, it’s a good idea to understand how the various pieces of your portfolio generally act when there is turbulence in the markets, but it becomes a problem when you’re constantly window-shopping to try to find the best hedges or diversifiers. Negatively correlated assets sound great in theory, but they also increase the odds of lowering your overall returns. You can’t eat risk-adjusted returns after all. Each individual fund or security you hold is much less important than how all of your investments function together to reduce the overall risk in your portfolio.

Short-term performance numbers tend to miss the main tenets of true diversification.

Diversification is not about:

·         Protecting you from terrible days, months or even years in the markets.

·         Hedging every single risk or hiccup in the markets.

·         Avoiding market volatility.

·         Sidestepping every market drawdown.

·         Finding strategies that will make you feel like a genius when the broader markets sell-off.

True diversification it about:

·         Protecting you from terrible results over long time horizons (the only ones that should matter).

·         Spreading your risks.

·         Ensuring you can survive severe market disruptions and still be able to achieve your longer-term goals.

·         Planning for a wide range of outcomes.

·         Managing your investments without knowing how the future will play out.

·         Reducing the probability of a large loss, but not completely eliminating risk altogether.

·         Not going broke.

·         Giving up on home runs to avoid striking out.

There’s no perfect way to completely hedge the downside of the markets while also enjoying all of the upside. Yet that’s what many investors are looking for when building their portfolios or hiring an investment manager.

Diversification isn’t about fully insulating your portfolio in the short term. Diversification can help at times in the short-term, but it’s really a long-term strategy.

They say perfect is the enemy of good. Investors miss out on good results by trying to be perfect. Trying to construct the perfect portfolio for every single market environment is a great way to own a bunch of competing holdings that don’t really get you anywhere. Plus, the ideal portfolio mix and strategy are only going to be known in hindsight.

The hardest part about long-term investing is dealing with the short-term movements in the markets. Diversification can help, but it’s not the be-all, end-all, nor should it be. Investors can’t expect to earn money in the markets if they’re unwilling to accept periodic fluctuations in their holdings.

Diversification works but it’s a strategy best suited for the long-term investor.