The Problem With a Well-Diversified Portfolio

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“Spread your risk,” say the financial planners.

“Diversify your portfolio,” say the stockbrokers.

I say, “Don’t listen to them.”

The idea of having well diversified portfolios is probably the best piece of spin doctoring to have come from the funds management industry in the last twenty years.

The problem with well-diversified portfolios is they usually aren’t well diversified. They tend to be diversified in the same direction. Look at the make-up of any ‘balanced’ managed fund. A fund split between Australian shares, international shares, property, bonds and cash isn’t a diversified portfolio at all.

In fact, based on the current market, three out of five of those asset classes require a bullish market sentiment. As for bonds and cash, they just cancel each other out – what you gain on the rise in bond prices you lose on the falling cash rate.

The problem is, when you diversify your portfolio too much across a single asset class or across multiple asset classes you tend to neutralize your returns.

For instance, what has a diversified portfolio done for most investors during the last eighteen months? Just take a look at the stock indices, that should paint a pretty clear picture of the damage.

Instead of investment managers preaching portfolio diversification, they should be telling clients to take a view and either stick with it, or have exit strategies if the view turns out to be wrong.

But of course, it’s not in the interests of fund managers to promote such a strategy. They want to convince you that managing investments is too hard for the average punter – leave it to them, your money will be safe in their hands… No thanks.

The key to investing really is to take a view and back your convictions. If you do that, and you’re right, then you’ll do much better than the average investor. If you get it wrong then you may do worse. But if you are actively managing your investments you can switch out of the investment if it moves against you. Traders do this all the time using stop-loss orders.

Let’s take the current market as an example. Last November when the S&P/ASX200 hit a low point, I – perhaps foolishly – called the bottom of the market downturn.

Does that mean you should have gone in ‘boots and all’ to the stock market last November. No, because I had an important caveat, and that was to look only for share market investments in the small cap sector and for those shares that are paying sustain a dividend payment.

In addition, my view was to stay away from finance sector stocks.

Four months later and little has happened to change that viewpoint. Let’s take the small cap sector as an example. Of course, I’ve a vested interest as editor of the Australian Small Cap Investigator newsletter. But the facts speak for themselves.

Since the market hit the previous low point in November the S&P/ASX200 has fallen by a further 3.28%.

In comparison, the stocks in the Australian Small Cap Investigator portfolio have gained by 16.59%. If you had diversified your portfolio across the whole market on the basis of market capitalization you would have received almost none of that gain from the small cap stocks.

As for the dividend paying stocks? Well, late last year I decided that it was almost time to release a new newsletter based on income investing. Now that interest rates have fallen to a pitifully low level, and many companies have slashed their dividends, I think that now is the perfect time to offer an income investing service to investors.

I’m currently putting the finishing touches to it, but hopefully we’ll be ready to launch in April. [Ed note: If you want to be among the first to find out about my new income service send an email to moneymorning@moneymorning.com.au and type “Keep me informed about your new income newsletter” in the subject line]

In my opinion, if you have a view on a particular asset class or particular investments, it makes sense to back yourself. Providing of course, you are prepared to accept the potential downside if you’re wrong. But that’s where your risk management strategy comes in.

If you really believe the banking sector is undervalued right now, why shouldn’t you load up your portfolio on bank stocks? Especially after CBA’s decision to maintain its interim dividend. But if bank stocks start to head further south then you’ve got to be prepared to cut your losses quickly. You can always jump back in again later.

Unfortunately, the only risk management strategy that many investors use is ‘diversification.’

Considering that investing is supposed to be about getting wealthier, sticking to the convention of diversifying will only result in your fund manager getting wealthier while you see your investments barely keep pace with inflation.

Actively managing and monitoring your short-term and long-term investments is the only way to keep ahead of the market and ensure you are not just an ‘average’ investor.

Kris Sayce
for The Daily Reckoning Australia

Kris Sayce
Kris Sayce, dubbed the ‘Jeremy Clarkson of Australian finance’, began as a London finance broker specialising in small-cap stock analysis on London’s Alternative Investment Market (AIM). Kris then spent several years at one of Australia's leading wealth management firms. A fully accredited advisor in shares, options, warrants and foreign-exchange investments, Kris was instrumental in helping to establish the Australian version of the Daily Reckoning e-newsletter in 2005. He is currently the Publisher, Investment Director and Editor in Chief of Australia's most outspoken financial news service — Money Morning.
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7 Comments on "The Problem With a Well-Diversified Portfolio"

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Fred
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My super fund manager recently sent me one of their cute little annual reports, err, I mean idiotic brochures, espousing: stick with it, don’t panic & switch now, its bad for all of us so don’t you feel so bad, blah, blah, blah. They even had an idiotic analogy about not abandoning a tropical island holiday mid way through because it had been raining for the last few days, and wouldn’t you feel like an idiot if after you left, the sun came out for the rest of the vacation? The flaw in their stupid analogy belies the flaw in… Read more »
Jack
Guest
Couldn’t agree more fred. My super fund still has this stupid article plastered over it saying the same thing with Data only up to June 2008. I agree that this sort of thing insults ones intelligence. Every time I ring them I ask them if they have the gaul to update it with the figures since then. I got my super into cash just before the meltdown (after being “advised” not to), and I have since asked them where the cash is actually invested – Govt bonds and the like. I have strongly suggested they come up with some new… Read more »
Paul Foye
Guest
Kris, I must say that I felt your article had no substance or truth or provided any information worthy of consideration what so ever. The messages I got from your article, was that you want to promote your services because you are obviously better than the planners and fund managers, and secondly, you are just as skilled at jumping on band wagons and playing to investors fears and feeling as all the others. It also reveals to me just how much you don’t understand the financial planning or funds management industry, but due to either your ignorance, ego, or insular… Read more »
Greg Atkinson
Guest

Paul I agree with you. Sometimes the DR articles really do not seem very “independent” all all.

Pete
Guest

The longer you read here the more you figure out who to listen to. Kris is a newsletter salesman – so that is what I expect from him.

The only authors I personally find reliably (mostly) unbiased are Bill and Dan, plus some guest articles now and then.

But as with anything you read, it is worth considering what the author wants out of the deal too. Find the bias and if it is a problem, then stop reading.

Still, this hardly even rates in bias when compared with the normal mass-media :)

Fred
Guest
Jack, your situation sounds similar to mine, money stuck in a lousy retail super fund, nevertheless working it. Several years ago, told their deaf trustee ears pinned to their dumb heads that they should have int’l cash and gold options. I too climbed onto the cash rock before the tsunami rolled in and washed away all the fancy investment sand-castles. I guess I have a trading-type attitude and reading of the DR and other similar webs to thank. Most DR contributors seem to be flogging gold or something, but that’s OK, as any sales pitch can be factored in. If… Read more »
Greg Atkinson
Guest

Pete there is no doubt that DR is much better than most of the rubbish churned up by the mass media. I do like the coverage on Bloomberg though.

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