June 29, 2021 | BY admin
“Diversification is the only free lunch in investing,” said Nobel Prize laureate Harry Markowitz. Why that is, and what it means to the average investor, needs some demystifying.
Proper diversification refers to having assets that move in opposite directions at the same time. In investing and statistics jargon, this is called ‘correlation.’ If one asset zigs, the other zags. For example, during the Covid drawdown in the first quarter of 2020, the S&P 500 fell 33.69% from February 13th till March 23rd. In that period, 20‐year treasuries (as measured by the iShares 20+ Year Treasury ETF) rose by 15.51%.
It’s analogous to the hitter in baseball that has a batting average of .315 but can go 4 for 5 in any one game. Nevertheless, over an entire season, he will always remain close to his average. Similarly, if you have many investments, you will earn their average over longer periods of time.
Many investors think that owning a few, or even many, stocks means you’ve assembled a diversified portfolio. The problem with this premise is that many stocks have a very high correlation (read: move in tandem). You would expect that stocks in the same sectors have a high correlation, but in today’s environment, the entire stock market moves in the same direction. For example, Target (ticker: TGT) has a correlation of .91 with Facebook (ticker: FB), which means they move in the same direction at a very high rate. What does a national retail chain have in common with the social media juggernaut? Only the fact that the market started moving in tandem.
In order to diversify, you need to incorporate many asset classes into your portfolio, such as equities, fixed income, real estate, precious metals and commodities. It’s also vital to have diversification in regions. Even within any one region, different asset classes can move in the same direction.
There is one type of false diversification that some investors think is helpful, and that is using more than one advisor. One of the biggest reasons one hires an advisor is to relieve them from managing the duties of their assets. But when you have more than one advisor, you’ll need to spend time and energy managing them as opposed to the assets.
Additionally, when it comes to actual management, multiple advisors’ work may be redundant. This does not add any diversification, plus, things can get hairy if they contradict each other. For example, to lock in a loss to offset gains, an investor can sell a position that is at a loss. This is known as tax‐loss harvesting. This only works if they don’t buy it back within 30 days. But if there are two advisors, the second one may purchase it in that 30-day time frame, causing a wash sale. This results in a tax bill, plus a headache. Having one quarterback managing and overlooking the entire diversified portfolio is probably the best way to invest for most.
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