by William R. Nelson, Ph.D
Chief Financial Strategist, Eqis Capital Management
The debate over the value of diversification will never end. Billions of dollars are at stake, the terms of the argument are not clearly defined, and many of those making their investment decisions based on their perception of the debate are not trained to make such an assessment in a scientific manner. Rather, typical investors who work as doctors, entrepreneurs, lawyers, and line workers make their decisions based on the advice of a trusted advisor who they typically choose not based on the advisor’s ability to perform and/or interpret academic and industry research but on the degree to which they think the advisor understands their goals and will be diligent in guiding them to fruition. In fact, the analytical/quantitative skills required for the research side are very rarely found in the same individual as the interpersonal skills required to quickly build trusting relationships. The investment industry accordingly best serves investors by combing both skill sets as yin and yang – the money managers and the client managers.
Eqis distinguishes itself from many competitors by consistently providing advice gleaned from the cutting edge research, especially that passing the highest standards of rigor required by the refereeing processes of the top academic journals. As you have likely heard, there are “lies, damn lies, and statistics.” The academic review process enlists top professors to approve articles for publication prior to acceptance at the top journals. The rate of acceptance is regularly in the 1% of submissions range, thus eliminating many of the “lying” statistics.
Below is a quick review of the recent top articles regarding the diversification of investments with my interpretation of their implications for investors and how this research impacts the allocations recommended to investors on Eqis. Recall that if we knew which asset class was going to go up next and which would go down, then we would buy and sell accordingly. But nobody knows this which is why we recommend investing in a way that does not require a crystal ball.
Question: What is there to do in an uncertain world?
Answer: Spread investments so no single bad investment costs you too much if it falls. Diversification thereby increases the expected risk-adjusted return over that of a concentrated portfolio.
Recently some have argued that “diversification is dead” because during the financial crisis of 2008 many asset classes and equity styles moved in similar directions. Here the most relevant and scrutinized evidence available is organized and explained so to put your mind at rest regarding whether to diversify your clients’ assets.
The first key is to understand that markets go up and down in somewhat random, often misunderstood ways, and to expect the status quo to persist is naïve. This first study from what is typically considered the top economics journal, The American Economic Review, is useful:
“The article seeks to explain correlation among global stock markets by examining capital account openness. History reveals that correlations among markets are not stable over time. The authors employ regression techniques to examine over the past 100 years both stock market correlations, and market openness as reflected by data provided by the International Monetary Fund on exchange restrictions. Their analysis shows that correlations among markets increase when capital is free to flow among nations.”
Dennis P. Quinn & Hans-Joachim Voth, 2008. “A Century of Global Equity Market Correlations,” American Economic Review, American Economic Association, vol. 98(2), pages 535-40, May.
Implication: Things change. Our portfolio today should not be fragilely balanced based on what happened last year, but robustly structured to persevere through all kinds of markets.
But some statistical studies have shown that during certain periods of time, namely hysteria, correlations among asset classes and equity styles can increase. This paper, published in what is typically considered the top finance journal, undermines other studies that find increasing correlations between asset classes:
“Analytical results show that the increase in conditional correlation could be a result of assuming conditional normality for the return distribution. When assuming a popular alternative distribution – the bivariate Student-tr – we find significantly less support for an increase in conditional correlation and conclude that this is due to the presence of fat tails when assuming normality in the return distribution.”
Campbell, Rachel A.J. & Forbes, Catherine S. & Koedijk, Kees G. & Kofman, Paul, 2008. “Increasing correlations or just fat tails?” Journal of Empirical Finance, Elsevier, vol. 15(2), pages 287-309, March.
Implications: Don’t be fooled into not diversifying because statistical results are often fragile. The safe strategy is to take the humble approach and diversify.
The extent to which broad diversification is important is becoming clearer and is shown again in another top finance journal:
“Global investors that ignore the industrial mix of the portfolios in which they invest can limit their potential diversification benefits in an economically important way.”
Griffin, John M. & Andrew Karolyi, G., 1998. “Another look at the role of the industrial structure of markets for international diversification strategies1,” Journal of Financial Economics, Elsevier, vol. 50(3), pages 351-373, December.
Implication: This paper explains not only that geographic diversification is valuable but that diversification across industries is also likely to increase the risk-adjusted returns for investment portfolios. Eqis diversifies in both ways.
Finally, a recent piece in The Journal of Finance, the flagship publication of the American Finance Association, determines the factors underlying correlations across international securities.
“First, there is no evidence for an upward trend in return correlations, except for the European stock markets. Second, the increasing importance of industry factors relative to country factors was a short-lived phenomenon. Third, large growth stocks are more correlated across countries than are small value stocks, and the difference has increased over time.”
Geert Bekaert & Robert J. Hodrick & Xiaoyan Zhang, 2009. “International Stock Return Comovements,” Journal of Finance, American Finance Association, vol. 64(6), pages 2591-2626, December.
Implication: Eqis uses these findings by recommending portfolios that are broadly diversified internationally, diversifying across industries by not using industry diversification to substitute for geographic diversification, and tilting portfolios when possible toward small value stocks for both their lower correlations and larger expected risk-adjusted returns.
Please consider the source when considering information and opinions regarding asset management strategies. For every true expert providing well-researched evidence, there are ten selling the snake oil or quick riches. Remember if something is too good to be true, it probably is. But prudently planned investing over the long-term can accomplish investors’ and advisors’ goals by avoiding mistakes, employing discipline, and maintaining focus on what’s important, establishing the wealth required to spend time with loved ones