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Diversification Means Always Having To Say You’re Sorry

03/09/2015

The following blog was originally posted on Yahoo Finance.

As much as any topic in finance, cargo ships of ink have been spilled on the topic of diversification. It is unquestionably the anchor to designing an effective portfolio of investments. Though first formally articulated in Harry Markowitz’s seminal 1952 paper on Modern Portfolio Theory (MPT), the idea is commonsense to all of us: Don’t put all of your eggs in one basket.

Because we don’t know what’s going to outperform, we spread our bets across a variety of investments. The trick, if it is one, as shown mathematically in MPT, is that we need to consider how the price of each investment varies in relation to the others. Assuming they don’t move in lock step with each other, there is inherent benefit in owning lower-correlated investments. Doing so allows us to hold a more “efficient” portfolio, meaning either: (1) for the same level of risk, we can earn higher returns or (2) we can achieve a similar return level but at reduced volatility.

Sounds good! But of course there’s a catch — and one that few have actually commented on. Being truly diversified means that there almost always will be a part of your portfolio that is sucking wind. (Big note: if every piece of your portfolio is working really well, it means one of two things: you’re incredibly lucky or you are not actually diversified. I would assume the latter.)

But what’s the big deal about that? Indeed, owning underperformers is built in to the definition. While statistically true, there is an unspoken behavioral component to this experience: We hate owning losers. And we fixate on the negative, drumming up feelings of regret and “if only” I (or my adviser) had tilted more toward fill-in-the-blank.

Examine, for example, one of the many “periodic tables” of asset class and key index returns. I like the one from Callan, but there are many others. And now look only at the bottom line of boxes to see the worst of every year. It reads as such:

2014: -4.90% (MSCI EAFE)

2013: -2.27% (MSCI Emerging Markets)

2012: 4.21% (Barclays Agg)

2011: -18.17% (MSCI Emerging Markets)

2010: 6.54% (Barclays Agg)

2009: 5.93 (Barclays Agg)

2008: -53.18% (MSCI Emerging Markets)

2007: -9.78% (Russell 2000 Value)

And so forth… And then another quick take on the data: Let’s look at the difference in the top performing investment class versus the bottom. Starting from 2014 back to 2007, the gap was: 19.79%, 45.54%, 14.42%, 26.01%, 22.55%, 73.09%, 58.42%, and 49.56%. In Callan’s table, the numbers are comparable going back to 1995. In fact, the 14% difference in 2012 is by far the smallest.

Two things are clear. One, a diversified portfolio will often have outright losers in it. Two, the gap between the top dog and the mutt is often very wide. The opportunity to feel regret is frequent. Alas, diversification usually doesn’t feel very good.

Last year stands as a good example of this discomfort. Take the following balanced portfolio allocation: S&P 500 (25%), Russell 2000 (10%), MSCI EAFE (15%), MSCI Emerging Markets (5%), Barclays Aggregate (25%), CS/Tremont Equity Market Neutral Index (5%), Bloomberg Commodity Index (5%), NAREIT Equity REIT Index (5%), and cash (5%). In sum, 55% equities, 30% bonds, and 15% alternatives (broadly defined).

The return of this reasonable portfolio in 2014? 5.2%. That’s right, just 5.2%. Plenty of asset classes performed poorly last year. The rub is that the S&P 500, by far the most popular proxy for “the market” returned more than 13% in 2014. Though that gap of about 8% is small compared to some of the big gaps mentioned above, many investors still seem to have a sense of frustration over their portfolios.

For a financial advisor serving investors in or near retirement, this balanced portfolio — especially after a multi-year tear for equities — strikes me as reasonable, maybe even tilting toward aggressive. It is this sort of diversified portfolio that most Baby Boomer and even Gen X investors should own. That said, “the market” made nearly triple this balanced portfolio and many folks aren’t happy. For financial advisers as much as anyone, diversification almost always means having to say you’re sorry.

Someone with a hammer often finds nails, so it’s no surprise that I see a behavioral explanation underlying these frustrations. I’d point to three behavioral quirks throwing sand in the gears: loss aversion, the fallacy of composition, and “if only” bias.

Loss aversion states that the pain we feel with losses is disproportionately large compared to the joy we feel with gains. A standard example is to compare the utility of a $100 loss versus a $100 gain. According to many studies, even though the loss and gain are the same amount, we find the loss much more aggravating than we find the gain enjoyable. Scientists often point to about a 2-to-1 ratio, meaning that we’d need to win $200 to feel enough happiness to offset the annoyance of losing $100.

Because we just showed that there are always losers in a portfolio, at least in a relative sense but also often in the absolute sense, we’re struck with the pain of knowing that something’s not working — a pain that often overwhelms the fact that plenty of other pieces are working.

One could reply that this is exactly why we build diversified portfolios — the whole eggs-in-basket argument and the inability to know what will outperform tomorrow.

But that’s where the second bias comes in. Our general cognitive tendency is to focus on pieces of the whole rather than the whole itself. Not only is it easier to focus on one versus many, it’s then that much more taxing to take on the relationships between the various pieces. When given transparency, we are not wired to see the one portfolio; we are wired to see the individual investments that comprise it.

This is where the “fallacy of composition” kicks in — a bias in which we reflexively assign the attributes of one piece to the whole. Applied to our portfolios, if something’s not working right now and perhaps losing a lot of money, then the portfolio overall is flawed, even “risky.”

Take a silly example: A portfolio that’s 98% in U.S. Treasuries and 2% in frontier market equities. You know the proportion, but as your adviser I show you a portfolio with just two line items. Assuming the bonds muddle along but the frontier exposure is extremely volatile, when the latter is down 40% (could happen), you will likely tell me I’ve built you a “risky” portfolio. But that’s clearly not the case. Down 40%, the frontier exposure cost you 0.8 cents on the dollar. If the frontier fund goes to zero, you would’ve lost just 2 cents on the dollar.

Thus, it’s difficult to “see” that portfolios which are actually on track to meet one’s financial goals are perceived as not on track and perhaps too risky.

Finally, there is the phenomenon of “if only.” The science of regret is complex, but a key takeaway is that how we initially benchmark success will be a key determinant of happiness. In our portfolios, if we measure our success (by calendar year, no less) by comparing all of our investments to the top performer at that time, then we’re doomed to be displeased. It is in fact natural to feel recently that “if only a lot more of my assets were investing in a S&P 500 index fund….” But that mindset of chasing recent performance is a sure ticket to not meeting one’s long-term financial objectives. Woulda shoulda coulda is not a strategy worth pursuing.

Ultimately, the math of diversification makes sense. It’s the psychology of diversification that is muddled. The path forward is not to rethink the former, but to accept and think through the latter. It is not a smart alternative to concentrate one’s portfolio in what one predicts will be the hot dot. At the same, it’s also unfair to ourselves to ignore that diversification is often a bitter pill to swallow — even when it’s good for us.

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Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.