"At Kobren Insight Management we build balanced, diversified portfolios."
It is a message that is oft repeated in the writings of, and employed
in the actions taken by the research team. While it is impossible to
predict market returns, risk is considerably more predictable and manageable.
By using diversified portfolios, we can appropriately mitigate the risk
taken in a portfolio to match the individual risk tolerances of our clients. (For
more on the importance of diversified portfolios, you can read Rusty
Vanneman's article here.)
When allocating a portfolio, there are many variables that need to be
considered. We have constructed these periodic tables with the hope that
they will provide some color on the importance of diversification.
The first chart is related to diversification by asset class. Over the
past ten years, an equal-weighted, balanced portfolio has, at times, outperformed
each of the key indices over a one year time frame. It has also underperformed
each of the indices in other years, but the relative performance of the
balanced portfolio has consistently generated returns that compete with
all asset classes over the long-term while also reducing the volatility
of the full portfolio.
The investible markets are subject to reversion to the mean. In other
words, a market will neither outperform nor underperform forever. The long-term
performance trend of most markets is one of positive expectations. Short-term
anomalies will eventually correct themselves. By mirroring this long term
up-trend of the investible market as a whole, a balanced portfolio exhibits
less risk than would otherwise be achieved by investing in only one asset
When constructing a portfolio, it is important to consider the style and
size of its holdings. While it is incredibly difficult to predict whether
growth stocks will outperform value stocks, or small companies will outperform
large ones, the Morningstar Style Boxes display the same mean reversion
characteristics as the broader market.
Note that the top performing Morningstar style box has outperformed the
bottom performing style box by an average of 32% since 1999. In only three
of the last 10 years did the top performing style box finish the subsequent
year with top quartile performance.
In addition to style and size, diversification of sector allocation can
prevent a down year in one segment of the market from dragging down an
entire portfolio. Any investor who put a lot of money into technology in
late 1999 or 2000 is probably well acquainted with the dangers of investing
without sector diversification!
An interesting point related to sectors is that they perform differently
in up- and down-markets. A 2006 study found that in times of economic crisis,
the relationship between sector returns become less correlated1. As we're
presently seeing, the risk-reduction benefits of diversification actually
increase in a bear market.
Investing internationally provides yet another opportunity to lower overall
portfolio volatility. This is because international equities do not correlate
perfectly with domestic equities. This is partly a result of companies
in other countries responding to a different operating environment (different
consumers, different government regulations, etc.) but also because investing
internationally diversifies a portfolio's currency exposure into
currencies other than the US dollar.
We recently heard from the commodities trader Victor Sperandeo. In response
to the recent headlines about corn, wheat, oil, and gold prices, he made
sure to note that unlike equities, commodities are so-called substitution
products. If the price of one good goes up, consumers will use less or
find an alternative.
Again, it is extremely difficult to predict what the returns will be in
these markets, and the returns can be incredibly volatile. For instance,
compare an equal weighted portfolio of the top three performing commodities
in 2006 vs. 2007. The 2006 portfolio would have seen returns of 119%; however,
the same basket of commodities would have lost 18% in 2007. Over the same
two year period, an equal weighted portfolio of all twelve commodities
returned 41% and 18%, respectively. In the end, a diversified portfolio
may give up some ground against a particularly hot sector, but it is stubborn
when the sector cools, and another takes off.
The benefits of diversification are twofold. First, by maintaining investments
in a variety of asset classes the pitfalls of performance chasing can be
avoided. The periodic tables paint a compelling story of the variability
and unpredictability of the market. Second, investing is an imperfect science,
and there are bound to be missteps. Diversification mitigates the effects
of making a big mistake, while participating in the long-term growth of
the global capital markets.
Bottom line: Over the long-term, it pays to have a balanced, diversified
1Beine, Preumont & Szafarz, “Sector Diversification During Crises:
A European Perspective,” May, 2006, DULBEA Working Paper Series
-- Gregory Kelly, Research Analyst