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Asset Allocation and Diversification
The Value of Proper Diversification
Diversification does not mean owning 3 different stocks. It means being diversified across multiple asset classes (up to 18 different asset classes), not just investing in stocks and bonds. As you can see from the Callan chart below shows the performance of different asset class over the past 10 years. You can see that it is difficult to pick a consistent winner from year to year. If you had to pick a winner for 2021, or for 3 years from now, 5 years, 10 years, 20 years, it would be almost impossible to do - even for a financial professional, let alone an individual investor.
While the above version of the Callan chart is useful, it has some limitations. What we prefer using are charts that show where these asset classes perform relative to a benchmark, such as inflation (CPI). The following chart shows just that:
There is a lot of valuable and usable information on this chart. Please spend a minute looking at the chart, and find the light blue boxes that represent "Cash Equivalents".
If you are currently sitting on large amounts cash, waiting for the economy or investment markets to be less volatile - this revelation is extremely important to you.
NOT ONCE OVER THE PAST 10 YEARS DID CASH EQUIVALENT PROVIDE A RETURN HIGHER THAN THE INFLATION RATE.
In other words, if you had a large portion of your wealth in cash or cash equivalents like savings, money markets, CD's, during the last ten years - you lost purchasing power. The longer you held those investments during the past 10 years, the more purchasing power you lost because you lost ground each and every year.
To see the entire Callan report - please click on here
and the report will open in a new window. Worth a review no matter how experienced you might be as an investor.
One of my favorite financial professional I work with, is always saying that if you are properly diversifying you client's portfolios, you are always saying your sorry. That is because one of the asset classes will be under performing at one point in time, or another. That is why I find this insightful chart about the value of diversification from Blackrock.
The most important part of this table is not that the Diversified Portfolio slightly outperformed the S&P Index, the most important thing from this table is that they achieved that performance with less volatility, which is what most investors want and desire.
INCREASE DIVERSIFICATION EVEN MORE WITH ALTERNATIVES
Alternative investments can be confusing, because there are so many different asset classes and investment strategies (Private Equity, Hedging, Futures, Commodities, etc.). Almost every Institutional Investment company has been adding alternative to their portfolio options, is because adding them into the asset allocation mix in the long run, adds value.
One way to see the effect adding alternatives is shown in the next two graphs. If you look at an "Efficient Frontier" graph of traditional investment options like the one shown here
The next graph shows the impact of adding alternative investments to the portfolio mix,
The addition of alternatives of even a small percent (10, 15, 25 ) to the overall portfolio generally moves the efficient frontier up and to the left. Why that is important, is that it translates into generating higher returns with less volatility. That is what every investor wants. Less Risk, Higher Reward.
A more detailed discussion on adding Alternative Investments as part of your portfolio is written by Black Creek. Black Creek is an investment firm providing several Alternative Real Estate Investments.
Black Creek Article
Another article about adding Alternative investments is from Morningstar
Morningstar Alt Article
If you look near the end of this article, you will see a graphic showing the Efficient Frontier, and how it moves up and to the left when you introduce alternative investments into the portfolio.
So why the different shapes of curves, if they are all measuring the same thing (relative risk / reward) using different mix of assets? The answer in part, is that the shape of the curves is greatly influenced by the correlation between the different asset classes. Here is a simplified correlation matrix from 2013. The correlation along the diagonal squares is always one (1.0). A correlation of 1 means that for every unit one class goes up or down, the other class goes up or down at the same rate. A correlation coefficient of 0.5 means that for every one unit that one class goes up, the other goes up 0.5 units.
The green squares indicate a positive correlation, the darker the green the higher the correlation is. The pink squares show a negative correlation.
The following is a correlation matrix from a KKR publication in October 2018 titled "Rethinking Asset Allocation" by Henry H. McVey, head of their Global Macro & Asset Allocation. You will see that this is a more complex correlation matrix, and the correlations are different than they were in 2013.
to view the entire white paper, or view it on KKR's website.
Please note that the color coding in this matrix is the opposite of the above correlation matrix, i.e. red colors indicate a positive correlation and the green colors indicate negative correlations. This makes more sense to me, as you want to identify asset classes that are not closely correlated with one another in building a diverse asset allocation model.
INVESTING IN PUBLIC vs PRIVATE COMPANIES
One of the Private Equity firms we work with is the Central Park Group. The are only available to qualified, accredited investors. Their website has an excellent Education section that contains information that most financial professional do not know. This is a short 4 minute video that should open your eyes about investing.
CPG EDUCATIONAL VIDEO
So you can see that the process of building an investment portfolio, if done properly, is more complex than just picking our a few mutual funds.
There is also a correlation analysis that can be done between mutual funds.
The last important thing to mention here, and it should be intuitive, is that the asset allocation models will be different for each person's unique situation, including time before they need funds from the assets, risk tolerance, and type of account. Assets that are in a normal brokerage or investment account is taxed differently and assets held in a retirement account like a IRA, SEP, SIMPLE, 401k or 403b plan.
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