Diversification At Market Peaks…

Recently, I sent an article written by Bill Bonner to a friend in the investment management business. First off, I love the mechanics of how Bill writes – seamlessly winding story and commentary together. Elegance in execution comes in many forms. Perhaps you prefer watching the standout quarterback pick out the receiver through a maze of defensive hands, or the soprano nail the aria, or the ballroom dancer glide across the floor. Whatever your choice, it is fun to watch a master at work.

At any rate, Bill’s commentary suggested that the U.S. equity markets were disastrously overvalued and that any sane person would exit. In response, my friend said, “Compared to what, and what alternative does he suggest?” Fair point. As if on queue, the next day Bill provided some suggestions, and then the story moved on.

We know that forecasts of gains and losses are – more often than a coin toss – incorrect. So, what are we to do? My reflexive response is simply to say, “Diversify.” But, what do I really mean when I say that?

Did Diversification Fail In 2008?
Late in 2008 through about 2010, we often heard or read that diversification failed. Since all asset classes lost value at the same time, it was a demonstration that the seminal theory of the past 60 years was off base. And, that all that portfolio theory should be thrown out. The popular notion was that by choosing asset classes that were not historically correlated, there was some sort of guarantee that all prices would not decline at the same time. In reality, this was a demonstration – as if another one was necessary – that the investing press and public did not pay close attention in high school or college statistics.

Building A Diversified Portfolio…
Entire semester courses are taught on this topic, but in a couple paragraphs, I’ll try to summarize.

The home base for any individual investment or portfolio is first to acknowledge that we cannot accurately predict the future. Those events we know with certainty end up being cancelled. Consumer sentiment changes. Regions are impacted by drought or a cyclone hits before the project is complete. Political winds change unexpectedly.

First up, we make a list of all asset classes that are to be included in our analysis. The theory says this should include a sample of all assets in the world – well past practical application for anyone but a giant retirement fund. So, we select as long a list of items that we have the time or capacity to analyze. For each item on the list, we will add assumptions for return, risk, and correlation.

The second step is to forecast returns for an asset class. This step is the most interesting and perhaps the most difficult. Historical returns make poor estimates of future returns and short-term returns are impossible to predict. Focus on a longer time frame – 10 years should be sufficient. Deconstruct the asset class into the various ingredients of return. Are investors paying a premium for the asset class? What are the expected cash flows? Assumptions for each piece will help us create our expected return. Precise analysis requires a quarter-by-quarter estimate with appropriate probabilities assigned, but for most of us, it’s more general.

Next, risk and correlation must be forecasted for each asset class under consideration. Once again, it is important to focus on the long term. With enough observations and estimates, a figure for expected variance can be generated. Historical observations can give us a taste of what to expect for risk and correlation, but beware, risk characteristics of asset classes can and will change. Increasing correlations will overpower the benefits of diversification.

Once these assumptions are complete, they should be combined into a decent mean variance optimization tool. The result is an efficient frontier, a set of portfolios that maximizes return per unit or risk. Don’t be surprised if this set of portfolios doesn’t look like the diversified portfolios at your favorite asset manager shop. Some asset classes won’t make the list – their return or variance or covariance will drop them as below par. Others will command unusually large allocations. These asset classes will need to be constrained so that the portfolio will fit an investor’s taste.

Simple as pie – eh?

So, Where Does Speculation Fit In?
The investment industry makes its money selling hope. Commission brokers and fee-based advisors (stay with a fee-only one, in my opinion), especially in years gone by, call clients to recommend individual stocks or products (often ones underwritten by their own firm). The major financial press and newsletters thrive on picking the best stocks for you to own. Actively managed mutual funds suggest that they somehow can consistently beat the market.

Literally, a mountain of analysis and academic research strongly suggests that this is simply not true. In articles I have written for the Daily Pfennig® newsletter, we have quoted studies that show less than 0.6% (that is six-tenths of one percent) of actively managed funds beat their index net of fees over the long term. Broker-assisted trading in one study provided the worst returns of any studied – that means below rolling three-month T-Bills.

But, price discovery does make a difference in the market. Without opinions and then trades, there would be no movement in prices and no one to set what, in theory, could be considered the “correct” price. When something slips out of line, traders and investors can step in to take advantage – either long or short – in the individual security until some sort of equilibrium is restored again.

In a previous article I discussed the alternative of outright speculation, but speculation only when the playing field has been tipped one way or the other.

The Bottom Line…
Now, back to my reflexive response. I still think that the term “diversification” could be the right approach. Great speculators can make a fortune through great analysis, playing on a tilted playing field, special situations, or luck. But, stacking up the asset classes, making some educated assumptions, and letting most of it ride for the long term suits me just fine.

You hear a lot from us about diversification, but do you practice this approach? Let us know by posting your thoughts in the Comments section of this blog.

Until the next Daily Pfennig® edition…

Onward and upward,

Frank Trotter
EVP & Chairman
EverBank Global Markets Group

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