Much Diversification Is Enough?
Crafting a Portfolio That Minimizes Uncompensated
Frank Armstrong III
- How could this happen?” investors ask when they read about
market disasters in the headlines. In fact, without the gross failure
of investment policy or implementation, they should never happen.
can be destroyed through a variety of well-known failures. High
up on the list is the failure to diversify properly. Diversification
is the one free lunch in finance and investment practice, and
prudent diversification is a prime responsibility of fiduciaries
under common law, UPIA, and ERISA. Diversification first and foremost
reduces risk to its lowest possible value.
diversification is enough? This article will look at how systematically
diversifying a portfolio can reduce risk at the portfolio level
while maintaining or even enhancing returns. While the balance
between risky and riskless assets is critical for each investor,
in order to illustrate the benefits of diversification, the first
place to focus on is the risky portion of the portfolio.
investors are able to meet their economic objectives while investing
in zero-risk instruments, they must assume some risk in their
portfolios. The trick is not to avoid risk entirely, because investors
are systematically rewarded for bearing risk. Instead, the challenge
is to manage risk prudently within each investor’s risk
tolerance, time horizon, and liquidity needs to meet personal
economists define risk in the investment process as the standard
deviation around the expected return of the portfolio. This concept
doesn’t resonate with many investors, who naturally think
in terms of not running out of money, not having a financial disaster,
or some other more personal definition of risk. But the link is
this: The higher a portfolio’s standard deviation, the higher
the probability that something awful might happen to the portfolio.
It’s not a far stretch to think of standard deviation as
a “danger index.” That is why all fiduciaries must
model the risk/reward characteristics of a portfolio.
while investors are compensated for bearing discrete factors of
market risk, they are not compensated for anything else. An investor
should ruthlessly pare away any uncompensated risk. Why would
investors bear a risk for which they are not likely to be rewarded?
The prime example of uncompensated risk is any risk that can be
reward may be related in the global sense, but they certainly
don’t have to be related in a portfolio. It is true that
all high-return investments carry high risks; however, the equation
can’t be reversed. Stated as clearly as possible, high-risk
strategies may not—and often do not—produce high rewards.
Investors lose sight of this at their peril.
It is important
to understand that excessive risk usually doesn’t work itself
out to an average return. A flameout anywhere along the way can
destroy the entire financial future of an individual investor.
In real life, investors can’t hit rewind and start over.
Relying on averages to bail out a flawed strategy rarely works.
much misunderstood relationship between risk and reward holds
true just in a special case: Risk and reward are related only
for securities in a fully diversified asset class portfolio. As
an investor moves away from a fully diversified portfolio, he
has no expectation of higher return, yet he bears more risk. Because
this additional risk earns no higher return, it is uncompensated
equity portfolio will be defined as the one equity portfolio that
has the highest expected return per unit of risk. It is possible
to construct an infinite number of portfolios with a 10% expected
return. Some of them will have absurdly high risk. But one of
them will have the minimum risk necessary to generate that rate
of return. That portfolio dominates all other strategies, and
every investor shooting for a 10% return should want to hold it.
class returns are plotted against risk as measured by standard
deviation, the appropriate relationship should be obvious. For
example, it is well known that stocks have a higher past and expected
return than Treasury bills, but carry more risk. Small companies
carry more risk than large companies, and yield higher returns
over time than larger companies. Investors demand that additional
return for bearing the additional risk. These additional rewards
are called risk premiums and spring from priced risk factors.
In an efficient
market, no stock can be expected to have a higher return than
any other with similar characteristics. If it did, buyers would
push the price up until the expected return was equal to other
similar stocks. If most investors agreed that one small company
stock had an expected return of 12%, while the other stocks of
similar size and book-to-market ratio (BTM) had only an 11% expected
return, the price of the first stock would adjust to where it
yielded 11% to the next purchaser.
If a company’s
prospects suddenly improve, that improvement will quickly be reflected
in its stock price, adjusting its future expected return to the
market average. News today travels at the speed of light, and
the opportunity to reap excess profits consistently is practically
individual stocks have widely different returns. Because no one
can predict the future, there is an enormous amount of noise and
uncertainty in the process. Some companies will do better than
average, and some will crash. But no one can know consistently
in advance which ones those will be. So unless one can outpick
millions of other investors looking at the same data, it’s
delusional to think any individual can consistently pick winners.
pay a high price when they try to beat the market. Of course,
transaction costs and taxes must be subtracted from whatever returns
are generated, lowering the effective rate of return. But by holding
less than the full market portfolio, an investor is bearing risk
without an expectation of higher returns. True, the variation
of returns is staggering. But in the net, the full market’s
returns will not be (cannot be) higher. Lower return and higher
risk is nobody’s definition of an optimal portfolio.
the concentration of holdings, the higher the uncompensated risk.
At the far extreme, consider an “Enron only” portfolio.
On the other end, consider a full market portfolio. Both had the
same estimated rate of return. But one portfolio is still standing
and growing, while the other vaporized.
stocks have a very high level of risk. The list below shows a
few well-known stocks with their annual standard deviation (std.
10-Yr Std. Dev.
of total loss is not adequately captured by standard deviation
at this level. Think of failures like Enron, Global Crossing,
and Eastern Airlines. While the probability of a total blowup
is small, the consequences are catastrophic.
are diversified within an industry group, but hardly a properly
diversified portfolio. Sector-fund investing is demonstrably not
prudent. Extreme variations in total valuation are possible. For
a sampling of how the risk of sector funds can match up with their
returns, see Exhibit
use the S&P 500 as an appropriate benchmark for the entire
But the S&P
500 is only one part of the optimum market portfolio. Adding an
equal weighting of large foreign companies in developed markets
will lower risk substantially (Exhibit
2). The most widely quoted benchmark representing this asset
class is the Morgan Stanley Europe, Australia, and Far East Index
But the S&P
500 and EAFE omit many midsized and small companies. The addition
of smaller companies to the portfolio (Exhibit
3) will further lower risk overall, because such stocks track
differently from their larger cousins (i.e., they have a low correlation).
market portfolio must be global in nature. It would be ideal,
but unfeasible, to hold a proportionate share of every traded
stock in the world. Today’s index funds and exchange traded
funds will capture in excess of 95% of the value of the world’s
capital markets. The risk level for the S&P 500 is substantially
higher than the global market. International investing offers
substantial risk reduction for long-term investors. A portfolio
that includes only large, domestic companies includes far more
risk than is necessary.
markets offer another opportunity to spread risk (Exhibit
4). While higher in volatility, their low correlation to developed
economies reduces risk at the portfolio level while enhancing
should consider the global equity market portfolio as a default.
Any investor who rejects the global equity market portfolio should
have a very strong belief set to justify such a position. Unfortunately,
it’s not unusual to hear variations of the following justifications
for an unbalanced portfolio:
- I work
for Enron. It’s a great company. I know what’s going
- I can
pick individual stocks that will beat the market.
- The United
States is the only place to invest. The rest of the word is
will outperform the rest of the market.
a doctor. I understand healthcare stocks.
Not all of
these people will see their portfolios crash and burn. The lucky
ones will prosper—after all, somebody wins the lottery every
week. But the majority will pay a heavy price for failing to manage
their risk properly.
more to diversification than just location. Research indicates
that investors may wish to overweight distressed companies (i.e.,
value stocks) to capture additional returns. Value stocks may
be viewed as a separate asset class with a low correlation to
the traditional large capitalization market (S&P 500 and EAFE).
While these risks are different, the total risk, at least as measured
by standard deviation, does not increase, and may even decrease,
when value stocks are included in a portfolio (see Exhibit
may correctly have different tastes for these additional risk
factors, so the weight of each within a portfolio may be adjusted
for individual preferences.
If the definition
of markets is expanded to include real estate and commodities
futures (see Exhibit
6), there will be additional opportunities to diversify a
portfolio and reduce risk.
In both theory
and practice, the portfolio with the widest diversification will
have the lowest risk. The Capital Asset Pricing Model (CAP-M)
tells us that the optimum equity portfolio is the whole market.
It’s the one with the highest return per unit of risk. Anything
less than the global portfolio is a bet against the efficient
market and subjects an investor to uncompensated risk.
Bonds in a Portfolio
even an optimum risky portfolio may be far too much risk for a
particular investor. The level of risk in an investor’s
portfolio should accommodate his risk tolerance, liquidity needs,
and time horizon. The appropriate way to accomplish this is to
vary the mix of high- and low-risk assets. The academic answer
is to utilize local zero-risk assets (Treasury bills in the United
States), but in practice, investors can substitute a very high-quality,
short-duration bond fund:
bonds, investors obtain a great deal of protection against volatile
markets. Risk drops off a great deal faster than return when bonds
are introduced into a portfolio. Investing at the appropriate
level of risk is the key consideration for success.
financial markets allow investors to diversify their holdings,
and today’s investment tools and products can provide effective
diversification at extremely low cost. The illustrated global
portfolio can be obtained by using a combination of traditional
no-load index funds and exchange-traded funds (ETF) at an average
weighted annual cost well below 0.5% at the fund level. It holds
more than 15,000 companies that represent more than 95% of the
value of the world’s traded stocks.
and Steady Wins the Race
Left to their
own devices, investors can find an almost endless variety of creative
ways to self-destruct. Do-it-yourselfers may have only themselves
to blame, but when an investor consults a financial advisor, he
has every right to expect a high level of practice standards,
professional knowledge, and fiduciary prudence.
for prudent diversification is the global market. Anything less
is a disservice to investors that fails to properly control risk.
people may disagree on the finer points of investment policy.
For instance, an individual investor may prefer to exclude either
REITs or commodities, or may wish to tailor exposure to small
companies or value stocks. Any policy tailored in such a fashion
should be described in detail in the investment policy statement,
accompanied by appropriate capital market assumptions and a risk/reward
model designed to meet the investor’s unique requirements.
should spend as much effort on the risk side of investment problems
as on the return side. Within broad limits, managing risk is more
important than driving up returns. Successful investing over an
individual’s lifetime should resemble the story of the tortoise
and the hare. If you think you just can’t stand to have
a boring portfolio, especially when everybody around you is talking
about today’s hot thing, just remember the tortoise. He’s
the guy with the low-volatility, fully diversified portfolio who
avoids unpleasant surprises and eventually wins the race.
here to view Disclaimer.
Armstrong III is the founder and principal of Investor
Solutions, Inc., a fee-only, SEC-registered investment advisor (www.investorsolutions.com).
He is also the author of The Informed Investor: A Hype-Free Guide
to Constructing a Sound Financial Portfolio (Amacom, 2003), now
available in paperback.