Is Your Portfolio Diversified?

eggs in one basket

Chris Johnson is a member of a 457 deferred compensation plan.  When Chris signed up for the plan a few years ago he was presented with the following options:

Fixed Income Funds:

  • Stable Value Fund
  • Bond Fund

Equity Funds:

  • Small Cap Fund
  • Mid Cap Fund
  • Large Cap Fund
  • International Fund

 

Chris decided that he was a long term investor and he could handle a risky portfolio.  Chris chose four different Funds to spread out his risk.  He made the following investment allocations:

  1. Small Cap Fund 25%
  2. Mid Cap Fund 25%
  3. Large Cap Fund 25%
  4. International Fund 25%

 

Recently, Chris reviewed his quarterly statement and he wondered if his investment plan was sound.  Is Chris Johnson’s portfolio really diversified? Chris seems to have selected all four of the equity funds and simply invested equally across all four Funds.  In Behavioral Finance this is known as “Naïve Diversification Bias”, a “1/n” strategy where n equals the number of funds selected.  In this case Chris picked four funds, ¼ = 25%, and placed 25% into each Fund.

The major problem with this portfolio is that it is only invested in one asset class, equities.  Chris is diversified within the equity asset class, but not at the portfolio level, because he doesn’t own any other asset classes.  Financial theory tells us there are two major sources of risk:

  1. Systematic Risk = Market Risk = Non-Diversifiable Risk
  2. Idiosyncratic = Company Specific Risk = Risk that can be diversified away

If we examine Chris’ portfolio we can see that there is probably very little company specific risk.  It’s all been diversified away because Chris owns small cap, mid cap, and large cap US stocks, plus non-US stocks in developed and emerging markets through the International Fund.  Although the idiosyncratic risk has probably been neutralized, there is a very high level of systematic risk in the portfolio.  If there is a systematic shock that affects markets, like the 2008 financial crisis, the above portfolio will probably not offer any diversification benefits.  This is tricky because Chris may have believed that he had his investments spread out over four different Funds, and would benefit from the diversification effect.  However, stocks tend to move in the same direction at the same time, whether they are small caps, large caps, or international stocks.  Do these four Funds really move in the same direction, or is that just theory?  Let’s take a look at what the relationship has been over the last 5 years.[1]  Following below is a correlation matrix that tells us how the returns of two different assets tend to move.  The scale is from -1 to +1 and can fall anywhere in between:

  • -1 = Perfect negative correlation = returns are always in the opposite direction
  • 0 = No correlation = returns have no relationship
  • +1 = Perfect positive correlation = returns always move together

The table can be read as follows[2].  The first horizontal row “Large Cap Stocks” show the following correlation statistics as you move across. Large Cap Stocks have a:

  1. .92 correlation with Small Cap Stocks
  2. .95 correlation with Mid Cap Stocks
  3. .96 correlation with International Stocks

 

Large Cap Stocks Small Cap Stocks Mid Cap Stocks International Stocks
Large Cap Stocks 0.92 0.95 0.96
Small Cap Stocks 0.92 0.97 0.90
Mid Cap Stocks 0.95 0.97 0.93
International Stocks 0.96 0.90 0.93

 

As you can see in this table all of these Equity Funds are extremely highly correlated, they are close to the maximum 1.00 of positive correlation.

What can Chris do to truly diversify his portfolio?  First, Chris needs to add additional asset classes beyond equities.  Once Chris has decided on the asset classes that he wants to invest in, he should construct a portfolio that takes into account asset class correlations, along with expected returns and volatility.  This process should help Chris to build a portfolio with real diversification benefits.  Further, with a properly constructed portfolio Chris should be able to target the same level of return that he expects from his current portfolio, with less volatility.

[1] Data for the 5-year period from May 11 2011-2016

[2] The following ETF’s were used as a proxy:  SPY = Large Cap, IWM = Small Cap, MDY = Mid Cap, ACWI = International

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