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Why diversify and the benefits to strategic asset allocation

Once you have determined your overall goals for your investment, it is time to come up with an investment strategy. The performance and volatility of a portfolio is driven by its asset allocation, and in the end the underlying exposures. Creating an asset allocation model will help to establish the right framework for diversification.

Diversification is an important step in achieving long-term financial success while mitigating risk along the way. There is a lot of research about diversification and its significance in portfolio returns. In fact, one of the arguments for investing in passive index tracking funds (ETFs) is that being diversified over time smooths out returns and lowers portfolio volatility.

There are studies that have shown that, during a period of low volatility, if you take a single stock that has the lowest volatility out of all the stocks in a particular index, the underlying index or basket of stocks will still maintain lower volatility than that specific stock. Meaning, one can achieve lower volatility through a diversified strategy.

Is having lower overall volatility important? I would say it depends – mainly on the time-horizon of the investment. But in general, one tends to sleep better at night when your portfolio isn’t fluctuating too much.

Common sense would suggest that it is best to not “stick all your eggs in one basket”, in this example – a few specific stocks.

 

To Diversify or Not to Diversify

For an investor who doesn’t have the time, experience, or conviction to make a bet on a specific investment, finding a vehicle that offers a diversified exposure is an effective way to invest.

There is a camp which opposes diversification in general. Warren Buffet was famously quoted as saying, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” Some believe that through diversification, although one mitigates risk by having different exposures offset one another, the opposite is also true, these exposures in turn offset potential gains.

Peter Lynch famously said, “Know what you own, and know why you own it.” On a fundamental level, I think Peter makes a lot of sense, but most of us aren’t Warren Buffet or Peter Lynch.

Which of us spends their entire waking day tracking markets and finding the next best opportunity? These investors literally “live and breathe” the bets they place. I can assume that the average investor can’t make the effort or feel confident in selecting specific underlying securities.

Strategic Asset Allocation

One of the pitfalls of investing can come from the “behavioral” side, as I alluded to in my earlier post. Humans tend to make emotional connections to their investments — holding onto something for too long, selling to early, or trying to “time” the market and make asset allocation adjustments at the wrong time, for example. I think diversification and sticking to an asset allocation model are tools to balance all these factors and achieve good results in the long run.

Another point I would like to bring up is that different types of assets perform differently in various market environments. This is well documented and can be attributed to the correlation between different elements of an investment portfolio. For example, historically, both US government bonds and gold have been seen as “safe haven assets.” During times of market stress, the “flight to quality” phenomenon comes into effect and those assets tend to perform better, acting as a hedge for other parts of your portfolio. This is not always the case, as we have seen during months where I have scratched my head and said: “Wow, everything went up, down or together,” but in general, having assets with varying levels of correlation between them is a way to achieve good diversification.

So, unless you are viewing this as a stand-alone investment, creating an asset allocation model can help you better understand how to diversify and what your expected return could be. You can incorporate historical return and volatility assumptions within your model to get a better sense of how your portfolio will behave in different market environments. A simple example model could look like this:

It is based on a “map” of what the investible landscape is, broken down on an asset class level. This can be broken down further by sub-asset class and the underlying vehicles to get exposure through. I think this is useful when getting to the portfolio implementation stage.

I hope that I have made some useful points on the benefits of diversification and implementing an asset allocation model.

I think one of the challenges we face as expatriates in Israel, is finding a way to achieve proper portfolio diversification while avoiding PFIC issues, for example.

In future posts, I will try to focus on some of the practical options expats that can use to achieve good portfolio diversification. Stay tuned…

Talk to the experts at Green Peak Advisors about adopting a holistic approach to investment– contact us today!