Outlook Update
Outlook Update

This may sting just a bit: Global diversification

 

“Diversification looks bad when it turns out you don’t need it.”
John Authers, Financial Times’ senior investment columnist,Oct. 25, 2013

While pondering whether I should get a flu shot this year, it dawned on me that I should follow our thinking on diversification. Volunteering to get poked by a sharp object may not be high on my wish list, but over time I believe it helps me stay healthy. Similarly, after two decades of studying and employing global diversification at Russell, I’ve come to the conclusion that when diversification is out of favor, it may be the right time to bet on its potential financial health benefits.

During my first month as Russell’s CIO, I’ve enjoyed talking with hundreds of clients.  In my interactions during at least three client conferences, I’ve encountered a range of generally happy folks. Of course, buoyant equity returns across most market segments year-to-date in 2013 tend to make for upbeat conversations.

Even so, I heard one recurring thread of concern: Are our portfolios too diversified relative to the home country bias at play in our peers’ portfolios?

A little context: U.S. small cap stocks, as reflected by the Russell 2000® Index, are up 40.6% for the 12-month period ending Nov. 8, 2013; international developed markets are up roughly 25.5%1, emerging market equities up 5.1%2, while commodities at -12.1%3 and bonds4 at -2.1% are not faring as well for the same period.

Why not get a second helping of the good stuff?
So, in this rewarding climate, why do we purposefully constrain the potential rewards by designing portfolios that are more diversified?  If the table is set for extra portions, why not help ourselves to seconds?

…Because we believe diversification is the closest thing to a “free lunch” that the marketplace has to offer, even though diversification does not assure a profit or protect against loss.  Periodically, however, over shorter horizons, I believe John Authers’ astute observation at the beginning of this post takes hold of many investors.

So, how does diversification help when you don’t appear to need it?

The investor who looks backward to conclude that they really didn’t need diversification is the same investor who simply wants to always invest in the asset class that will deliver the highest return. Well, the wanting and the doing of such prescient practices are about as far apart as the partisan debate over debt ceilings in Washington.

In fact, when I posed this value-of-diversification question to Steve Murray, our director of asset allocation strategies, he gave me that “look” I often get from our researchers, and pointed me to some of the core asset allocation concepts we often provide to clients. Several take-aways jumped off the page at me, so here are some key points from a research perspective, along my own interpretations:

  • Researcher: Diversification is the cheapest mechanism for managing portfolio volatility and protects against imprecise inputs. Translation: Safeguard your money from hubris.
  • Researcher:  Concentrated positions reflect an allocation that is premised on only a subset of the available input data and is likely to favor investments with the largest (positive) estimation error. Translated: Shiny objects may appear larger in the rear-view mirror.
  • Researcher: Diversification includes not just asset classes, but factor and regional exposures as well as various active and passive return sources.  Translation: Our best friends don’t always live next door.
  • Researcher: Portfolios should have representation across asset types including equities, fixed income, real assets and alternative investments based on what has been assessed as within the bounds of a client’s risk tolerance. Translation: Eat a balanced diet, and don’t overlook your vegetables.

In short, diversification, although it doesn’t promise gains nor protect against loss, remains even more essential when the market environment tempts us to shift increasingly toward concentrated exposures. Tilting a portfolio in response to market opportunity, as Russell has done with some success over the last year, often makes good sense, as long as we recognize the difference between reasonable diversification and radical diversification — more on this in my next post.

OK, bring on the flu shot.


1 Russell Developed ex-U.S. Index, for the 12-month period ending November 8, 2013

2 Russell Emerging Markets Index, for the 12-month period ending November 8, 2013

3 Dow Jones UBS Commodity Index, for the 12-month period ending November 8, 2013

4  Barclay’s U.S. Aggregate Bond Index , for the 12-month period ending November 8, 2013