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Analyst Spotlight: Greg Kelly

It Pays To Have A Balanced Diversified Portfolio

Gregory Kelly

"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 class.

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 portfolio.

1Beine, Preumont & Szafarz, “Sector Diversification During Crises: A European Perspective,” May, 2006, DULBEA Working Paper Series

-- Gregory Kelly, Research Analyst



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