Broker Check

Diversification Means Being Uncomfortable!

January 02, 2019

Happy New Year!

The following is an excerpt of a letter written by Larry Swedroe of Buckingham Asset Management

Please contact your SFM advisor with any questions.

Adam Butler of ReSolve Asset Management once offered the following observation: “Investing provides a premium because it is uncomfortable. The more experience I accumulate in this business, the more I have come to believe that the returns an investor can expect to achieve are directly proportional to the amount of discomfort that they are willing to tolerate.”

Investors face a choice. They can either own a traditional market-like portfolio, which has the vast majority of its risk concentrated in the single factor of market beta (for a typical 60 percent equity/40 percent bond portfolio, it’s almost 90 percent), or they can choose to diversify across as many unique sources of risk and return that have been identified and meet all the criteria we established earlier (persistence, pervasiveness, robustness, implementability and with intuitive explanations for their persistence).

The first path is the comfortable one in the sense that your portfolio will not cause any tracking error regret — you won’t be underperforming popular benchmarks that are reported on daily by the financial media. On the other hand, the traditional market-like strategy will likely be highly uncomfortable during periods like 1973-74, 2000-02 and 2008, when the single-factor (market beta) that dominates such portfolios’ risk suffers from severe bear markets.

Failing conventionally is always easier than failing unconventionally (misery loves company). Based on the historical mean and historical volatility, the market beta premium should be expected to be negative about 9 percent of the time over 10-year periods. However, we should expect more frequent failures in the future because current valuations are much higher than historical valuations. Thus, we should expect a smaller premium. From 1927 through 2018, the market beta premium was 8.5 percent. Most financial economists expect it to be much smaller going forward, perhaps half as much. A smaller premium with the same volatility means greater odds of negative returns.

The second path, diversification, could lead to a higher chance of successfully achieving goals. However, it does mean having to live with the fact that your portfolio will perform very differently than traditional portfolios, creating the risk of tracking error regret. In that sense, diversification is not a free lunch. It means living through uncomfortable periods, even long ones. And, during periods of failure, it means failing unconventionally, which is much harder to deal with.

Given that you must accept you will have to live through uncomfortable times whichever path you choose, it seems logical that you should pursue the path that could give you the highest odds of achieving your goals. And that is choosing the more efficient portfolio, the more diversified one.

I’ve always believed that the greatest anomaly in finance is that while investors idolize Warren Buffett, they not only fail to follow his advice but often do exactly the opposite of what he recommends. That is what led me to write “Think, Act and Invest Like Warren Buffett.” Let’s consider the following advice offered by the “Oracle of Omaha” in his 2004 Berkshire Hathaway shareholder letter:

“Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”

When the stock market is meeting our best expectations, thinking about the market’s inevitable up and down cycles and the benefits of a disciplined approach sounds reasonable, even easy. Yet, when the market goes down, it often feels different, maybe difficult. That is explained by the tug of war between our emotions and our reasoning. Which side wins? French philosopher Blaise Pascal declared: “All of our reasoning ends in surrender to feeling.” Our job as your advisor is to prove Pascal wrong!

Investment Advisor Representative, Investment Advisors, A Division of ProEquities, Inc. A Registered Investment Advisor, and A Registered Broker-Dealer, Member FINRA & SIPC Security Financial Management is independent of ProEquities, Inc.