Diversification is a very good thing. As the saying goes, it’s the only free lunch in investing.
By divvying up our money into a wide range of asset classes, countries, and types of stocks, we can reduce, but not eliminate, our investment risk.
From an academic perspective, because unique asset classes are not perfectly correlated with one another (they don’t move in lock-step), a portfolio will have less risk than the weighted sum of its individual parts.
Window Dressing and Intentional Complexity
However, there is a difference between truly functional diversification that actually serves to mitigate risk and the artificial, warm and fuzzy “diversification” I often see in portfolios.
The worst part is that this false diversification occurs not only in the portfolios of retail investors, but also in portfolios designed by professional advisors.
Often, when it comes to advisor-managed portfolios, this amounts to nothing more than window dressing and the creation of intentional complexity.
In other words, the advisor builds a hyper complex portfolio to justify their own existence (and often high fees), even though it provides no benefit to the client. In reality, it typically does more harm than good.
Intentional Complexity in Portfolio Design
Other times, the advisor falsely believes they possess a high probability of picking the right managers. They proceed by selecting multiple funds to fill each of a dozen or more different buckets.
False Diversification and the Illusion of Safety
Ultimately, however, this is nothing more than a fake security blanket. Valuable diversification can be achieved through several different strategies. However, the following, in and of themselves, do nothing to support that effort:
For some very odd reason, many investors and advisors alike seem to think that there is risk in having all of your assets invested with a single fund company.
The generally good rule of thumb “don’t put all your eggs in one basket” is mistakenly used to justify investing with 10 or 20 different fund companies. Let’s look at why this is a poor way of thinking about your portfolio:
1. The underlying stocks and bonds you own matter much more than the managers who purchase them on your behalf
We know from extensive research and evidence, that the vast majority of managers fail to beat their benchmark. This is true in every asset class and has held for long periods of time (it’s simple math).
Thus, rather than concerning ourselves with how to assemble a portfolio with a bunch of different managers and hoping that they’ll outperform (against very long odds), we should be much more focused on the types of stocks and bonds we want to own.
This is because it is the underlying risk/return profile of the portfolio, its expenses and taxes, and your ability to stick to your plan that will be the biggest drivers of returns.
Once we know what types of stocks and bonds we want to own, we can make allocations to these asset classes using low cost, passively managed funds or ETFs to ensure we capture the asset class return.
2. Manager tug of war
Let’s assume you are a believer of active management and you think that certain fund managers can beat the market.
Well, practically speaking, how will they do this? There are really only two ways for a fund manager to legitimately outperform their benchmark:
- Correctly time the market – Minimize market declines by moving to cash before a downturn and take advantage of buying opportunities by investing when the market is near a bottom
- Pick the right stocks – Overweight the winners and underwight (or, ideally, eliminate) the losers
So let’s say you have a portfolio with 20 different managers. What are the chances they all believe the same thing at the same time? Probably pretty low.
So you might have one manager moving to cash, while another sticks it out believing the bull market still has legs. What one manager does offsets the other manager meaning you are 50% invested with this part of your portfolio. Yet you are paying 100% of the fees.
This tug of war means that unless you are willing to let a single manager make tactical bets with your entire nest egg, you’ll likely accomplish very little by having a long list of managers in your portfolio.
3. Mutual fund investors own the securities held by a fund and are protected from a mutual fund company’s creditors
When an investor purchases shares of a mutual fund, they own their respective share of the underlying companies held in the fund. So if the fund company goes under, your investment does not go with it.
Likewise, your assets are legally separate from the assets of the mutual fund company. Their creditors have no claim against your investments in the event of a bankruptcy or reorganization of the fund company.
Thus, there is no tangible benefit from owning funds from several different fund providers, unless each of those funds are best of breed to begin with.
More Funds Means More Diversification, Right?
For a lot of advisors, this is their bread and better. They recommend very complex portfolios with 15, 20, or even 30 different funds. They explain their rationale with lots of catch phrases that sound really good, but actually don’t say anything real about the portfolio:
- “The managers we’ve chosen on the bond side have a “go-anywhere” mandate. This means they can minimize downside risk, but capture upside returns.”
- “We like alternatives because stocks and bonds don’t provide enough diversification.”
Rather than looking at the characteristics of the overall portfolio, they focus on the individual slices. The end result is a failure to focus on the things that truly matter:
- Have we aligned the investor’s unique risk profile with their portfolio?
- What are the risk factor (or, more generally, asset class) weightings in the portfolio?
- How are we allocated across U.S., foreign developed market, and foreign emerging market stocks?
- Are the bonds we’re investing in appropriate relative to the stocks in the portfolio?
- What are the tax implications of the portfolio?
In a lot of cases, I would venture to guess that many advisors have never even spent the time to understand the total portfolio they’ve built. They spend so much time selling the sizzle, they forget about the steak.
Long story short, you should care much more about the overall characteristics of the portfolio, rather than how many funds it takes to get there.
In fact, the fewer the funds typically the lower total cost of ownership and the greater the tax efficiency.
On almost a weekly basis, I see portfolios with a dozen or more different managers in them. If the portfolio was deveoped by an advisor, they can probably tell you a lot about the fund company, the manager, and their strategy.
However, they often know very little about the underlying securities and the total portfolio (other than maybe the broad stock versus bond split). As we’ve seen, this may be an intentional for any number of different reasons.
However, don’t let name diversification or a multitude of funds lull you into thinking you are diversified. Only by owning a wide swath of stocks around the world, complimented by high-quality bonds will you eliminate unnecessary risks in your portfolio.
To illustrate, a typical portfolio I recommend has the following characteristics:
- Owns 8,000 to 12,000 stocks across the globe
- Invests in 40+ countries, including the U.S., international developed markets, and international emerging markets
- Is diversified across unique risk factors, including small cap stocks, value stocks, and stocks of profitable companies
- Contains high-quality bonds designed specifically to reduce overall portfolio volatility