Diversification

One reason that many investors are reluctant to invest much in the stock market is that they know many stories of companies and stocks that have suddenly come on hard times. Some investors imagine an investment in the stock market to be like that — just when their investments have gone very high, it may be just the time that they are about to fall sharply. The mistake in this logic is that they forget that, while a single stock may rise or fall dramatically, the movement of the overall market over time has been generally upward and much more subdued.

Modern Portfolio Theory (MPT) provides the reason. It explains that two effects govern the movements of stock market and stock-specific events. It is primarily the stock-specific events that cause individual stocks to move up or down wildly relative to the overall market.

You may think your best protection against stock-specific risk is to use portfolio managers who know all the companies in your portfolio. The trouble is, the events that cause the most damage to stocks usually come as a complete surprise. For example, a company may have a sudden product liability problem or the chairman may die. On the upside, a company may make an unexpected new product announcement or land a major contract. Such events often cause price movements that not even the best portfolio managers expect. In fact, even if an event is anticipated, MPT tells us that the effect of the event is rapidly evident in the stock’s price and no further profit can be gained from knowledge of that event.

If surprises move stocks, then how can an investor protect a portfolio against them? The answer is diversification. The stock-specific movements of individual stocks may not be predictable, but with a diversified portfolio they tend to cancel one another out.

MPT tells us that we can build diversified portfolios to greatly reduce stock-specific risk, but that market events, which affect all stocks, are not diversifiable. That is, even a diversified portfolio of stocks is subject to the overall movements of the market. Fortunately, the theory predicts that the market rewards us for taking this risk by giving us generous long-term growth potential. The asset allocation decision is where we decide how aggressively to pursue this long-term growth (and tolerate the related risk).

On the equity side we believe in extensive diversification, both within each asset class and across asset classes. In addition to the domestic asset classes, we typically allocate nontrivial fractions to international asset classes and hard assets (real estate and commodities). We diversify along dimensions of risk formalized in the Fama-French three-factor model: equity, small-cap (size) and value. We believe the three factors correspond to distinct dimensions of risk. This is a prevalent view in the academic world as well as among a wide range of investment professionals and institutional investors.

We do not believe in what is known as “active” investing: attempting to beat the market by identifying mispriced securities (stock picking) or forecasting the direction of the market (market timing). There is a large and widely accepted body of academic evidence to indicate that such pursuits are not expected to add value to a portfolio commensurate with the costs involved.

We view the fixed income portion of a portfolio as a diversifier and risk-dampener for the equity portion. As such, we avoid volatile fixed income classes, such as long-term bonds, junk bonds and mortgage-backed securities. Instead, we feel the risk-expected return characteristics of a portfolio can be improved if any additional expected return is addressed by varying the stock/bond mix. There are solid arguments, both empirical and theoretical, supporting this view. Therefore, we restrict fixed income investments to high quality, short- to intermediate-term bonds. Since there isn’t much differentiation between such bonds, diversification across a very large number of securities in this asset class is not as important. For this reason, our experienced fixed income team builds customized portfolios of individual bonds for our clients — without trying to predict the future direction of interest rates, changes in the shape of the yield curve or variations in credit spreads.

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