How to tell if your investment portfolio is really diversified. Hint: Don’t focus on correlation.
In this episode, you’ll learn:
- What is correlation as used in Modern Portfolio Theory and what are its flaws.
- What three questions should you ask before you make any investment.
- What are the characteristics of a perfect portfolio.
- What is a asymmetrical risk-reward pattern.
- Why timber is an attractive asset class.
- What is the primary driver of stock returns.
- What is the return driver for distressed debt investing.
- Why owning a rental property can be an attractive investment.
Bill Ackman and His Hedge Fund: Betting Big by Alexandra Stevenson and Julie Cresswell In the episode, I mistakenly said this Bill Ackman article was from the New Yorker. It was actually published in the New York Times.
Are You Sure You’re Diversified?
When I was an institutional investment advisor, one of my firm’s duties was to produce the occasional memo for clients addressing whatever particular fear was driving the markets at the time. What was the lead story that had everyone worried.
Invariably, these memos concluded with the importance of diversification. “Diversify and you’ll be able to ride out the storm,” was the message.
The term “diversification” has been used so frequently, including in our memos, that it is a platitude, a cliché.
Seldom do we stop to ask, “Is my investment portfolio really diversified?” “What does it even mean to be diversified?”
In traditional Modern Portfolio Theory (“MPT”), diversification means to construct an asset mix that minimizes the volatility (both the ups and downs) for a given level of expected return.
A key assumption in asset allocation models based on MPT is correlation, which measures the degree to which the returns of one asset type (i.e. U.S. stocks) move in tandem with the returns of other asset categories (international stocks, bonds, commodities, etc.)
The problem with relying on correlation assumptions to determine “an optimal” asset mix is correlations aren’t static. Correlations change based on the market environment.
During the 2008 financial crisis, many asset types that were assumed to be uncorrelated became highly correlated as they plummeted in value together, leading to massive losses for investors.
This is yet another flaw in Modern Portfolio Theory, which I have written about in previous columns.
Instead of dubious statistical models, I prefer a more qualitative approach to diversification that is based on answering three questions.
1. What are the primary drivers of the potential return for this investment?
2. What can be done to minimize the likelihood of losing money on this investment?
3. Is the potential upside of this investment significantly higher than its potential downside?
A perfect portfolio is one in which the investment holdings have different return drivers, the downside is limited and the upside is massive.
Unfortunately, perfect portfolios like perfect people don’t exist. Still, it’s helpful to have a standard to measure against.
Here’s an example of answering the three questions.
A number of my former investment clients invest in timber.
What is the primary return driver for a tree farm? The fact that trees grow. Each year the value of the timber increases because the trees grow bigger so there is more wood.
The risk of loss on timber investing can essentially be eliminated by owning trees in different areas, buying them when they are still young and holding them for 20 years or more.
This avoids the rare but extreme events of forest fire and disease. It also allows maximum exposure to the primary return driver — the ongoing growth in trees.
The beauty of timber investing is if wood prices are depressed in a given year, timber owners aren’t forced to sell into a crummy market. They can store the value “on the stump” as timber investment managers like to say.
Timber investing exhibits an asymmetrical risk reward pattern. The upside potential is significantly greater than the downside risk.
Stocks and Real Estate
Now contrast timber investing with owning a handful of stock mutual funds. The primary driver of a stock portfolio is corporate earnings growth, which is a function of a nation’s economic growth.
As global economies have become more interconnected, shifting from one mutual fund, say a U.S. stock fund, to an international equity fund, doesn’t really change the primary return driver. It is still global economic growth. Consequently, holding a variety of stock funds isn’t really diversification.
If one holds stocks and owns a rental house near a large private university then diversification increases. The primary return driver for the house is rental income, which is tied to the growth of the university.
Understandably, many investors can’t own timber or rental houses. The point is don’t be lulled into a false sense of confidence that you are diversified when in reality you are not if the primary return drivers of your investment holdings are the same.