The Realities of Diversification

Insurance policies always carry a premium that must be paid to the insurer by the insured in exchange for protection against an adverse event. It would be nice to receive a huge payout for free when something unfortunate happens, but that isn’t reality. Most of us understand that concept well, but investors too often lose sight of that simple concept when it comes to portfolio management.

Investors forget that portfolio diversification is an insurance policy against one’s view of the world being incorrect. Like all insurance policies, diversification comes with a premium that must be paid. However, investors seem to believe that portfolio diversification is available without an insurance premium. People realize the fantasy of an insurance policy that comes with no premium, but somehow investors remain captivated by the idea that portfolios can be diversified without hindering performance.

At RBA, we try to invest in negatively correlated asset classes rather than uncorrelated asset classes. Whereas uncorrelated asset classes (other than cash) sometimes lose their diversification properties during bear markets, that more rarely happens to negatively correlated asset classes. However, because negatively correlated asset classes generally underperform during an equity bull market, investing in negatively correlated asset classes can be a drag on performance.

That drag on performance is the insurance policy premium.

What if there was no risk?

If one knew with 100% certainty that there was going to be a bull market over the next 12 months, then one would likely be 100% invested in equities. It might be prudent under those circumstances to invest in high beta stocks or to borrow to be more than 100% in equities or both. Investors tend not to do those things because they cannot perfectly predict equity returns. However, “aggressive” portfolios tend to be less diversified, whereas “conservative” portfolios tend to be more diversified.

Chart 1 compares the returns of the S&P Target Risk® Aggressive Index with those of the S&P Target Risk® Conservative Index. The more aggressive index currently has roughly 80% in stocks. The more conservative index accentuates asset classes such as bonds (roughly 70%). Chart 2 highlights the 12-month rolling volatility of each portfolio.