Diversification: Friend or Foe?


min read

June 25, 2019

Even if you don’t consider yourself to be a savvy investor, chances are you’ve heard about diversification. The age-old idea of not having all your eggs in one basket is considered timeless wisdom, but could it be working against you?

In truth, diversification is a double edged sword. The benefit that it provides comes at a mighty cost. When it comes to investing, most individuals aren’t aware of the hidden price they pay for this so-called “free lunch.”

In this article we’re going to look at some of the finer aspects of diversification, and discuss its role in an investment portfolio. Whether you’re risk-averse, or risk-seeking, you’ll benefit from understanding the trade-off you make every time you adjust your investment portfolio.

What is Diversification?

You know what diversification is from a philosophical standpoint, but when it comes to investing, exactly what is diversification? And how do we measure it?

At it’s core, diversification is the concept of including multiple investments in a portfolio in an attempt to reduce overall portfolio volatility (risk), while still maximizing returns. This risk management technique attempts to eliminate unsystematic risk (more on this in a moment) by allowing the positive performance of some investments to neutralize the negative performance of others.

The key to diversification lies in what are called non-correlated assets. These are assets (think stocks, bonds, real-estate, gold) that generally move opposite the direction of other assets in the financial markets. By including these types of assets in a portfolio, a “buffering” effect can be achieved whereby when one asset is declining, another tends to be rising.

While this all sounds great in theory, effective use of diversification still remains a challenge for the majority of individual and institutional investors. This is because most investors don’t realize the massive changes that have taken place in financial markets over the past few years.

The Benefits

Earlier I mentioned that diversification attempts to eliminate unsystematic risk (also known as  “specific risk” or “diversifiable risk”). These are the company or industry-specific hazards that are part of every investment.

If you want a perfect example of unsystematic risk, think of Enron. Those who owned Enron as part of, say, an S&P 500 index fund that invests in the top 500 U.S. companies, barely noticed the implosion. Those who held larger individual positions were hurt badly.

Unsystematic risk is not constrained to individual companies either, it can affect entire industries. Other examples of unsystematic risk include new competitors, regulatory changes, management shakeups, or product recalls.

This notion of being able to diversify away company or industry-specific risk leads many investors to adopt a “more is better” mentality. They figure the more assets they add to their portfolio, the better protected they’ll be. Unfortunately, that’s not the case. Adding new investments to a portfolio can actually reduce your level of diversification. To understand why, we’ll need to dig a bit deeper.

Understanding Correlations

The degree to which two items vary together, such as stock returns and bond returns, can be measured by looking at their correlations. Correlation coefficients range from +1 to -1, with +1 representing perfect correlation, zero representing no correlation, and -1 representing perfect inverse correlation (they move opposite directions).

Diversification only provides a benefit if the new investment you are adding is not correlated with the other assets in your portfolio. If your portfolio and the new investment ARE highly correlated, then you’ll be adding little value, and could actually be harming your overall portfolio.

The table below shows correlation coefficients over the last 8 years for major market segments. You can use it to get a feel for how correlated different markets are. To read it, find the intersecting value for the two funds (market segments) that you are interested in.

One important thing to notice in the table above is that bonds have a negative correlation with the overall stock market. This is why traditional portfolio management advocates splitting a portfolio between stocks and bonds … when one is declining, the other should be rising.

But think about what that means for a moment …

The Drawbacks

If a properly diversified portfolio implies that different investments will always be moving in different directions, then what does that mean for the overall portfolio? If you said lower returns, pat yourself on the back.

Think about it this way: If you had an absolute perfectly diversified portfolio, it would never change value. Every time one of your investments went up, another would go down, leaving your balance unchanged. Sure, you’d essentially have a risk-free portfolio, but how beneficial is that? The whole point of investing is to accumulate wealth.

What I’m getting at here is simple, there is a trade off between risk and reward. As we diversify our portfolio further and further, we reduce our risk (portfolio volatility) but we also reduce our expected returns. Thus, diversification should be viewed as a sliding scale,  as depicted below.

On one side we have high diversification, which is accompanied by low risk and consequently, low returns. On the other side of the spectrum we have low diversification, which implies high risk and high returns. Somewhere in the middle is an optimal range, which represents a balance between the returns we seek, and the amount of risk we are willing to take.

The optimal range is of course different for everyone, but interestingly, it’s not as different as you might expect. This is because the requirements placed upon each of us in terms of saving for retirement are quite similar. We all face the same situation. We must save during our working years, earn a high enough rate of return to be able to retire comfortably, and then keep those investments growing through retirement as we live off of them.

This, by definition, entails a certain level of risk, and tends to put a lower bound on the level of expected return we can accept. On the other side, we find that because a minimal level of diversification produces such a profound reduction in risk (relative to its effect on return), that this too has a logical lower bound.

So in sum, we can’t accept too much diversification because our returns will be nonexistent, and we can’t accept too little diversification because we’d be foolish not to allow a basic level of diversification to eliminate unsystematic risk.

The trick is to find the “right” level of diversification that eliminates the most risk with the least effect on overall returns. So how do we do that?

Finding the Right Balance

While we’d love to give you some formula to figure out how diversified your portfolio should be, the fact is we can’t. There are just too many complexities involved. The near-infinite number of investment options, account types, and changing correlations (yes, did we mention correlations don’t remain static and are constantly changing?) make this nearly impossible.

But what we can do is provide some guidelines, and show you how we approach this issue here at Sigma Point Capital.

In our experience, most people understand intuitively that having a stock portfolio with just a few stocks in it is a bad idea. In this case, mathematical models show that by including around 25-30 stocks, most of the unsystematic risk can be removed. As the number of stocks you own rises above that level, the diversification benefits continue to improve, but at a much smaller rate.

These days, with the advent of Exchange Traded Funds (ETFs), which are our preferred investing method, it’s easy to own baskets of stocks in whatever industry or segment of the market you like.

The bigger issue, in our opinion, is how most investors are approaching diversification at the asset class level. This is the fundamental decision regarding how much of your portfolio to have in stocks vs. bonds vs. cash at any given time.

Most schools of thought suggest that investors always split their investments between stocks and bonds due to the negative correlation between the two asset classes. But if you think about it, this means that over the course of your life, one major component of your portfolio will always be dragging down your overall returns. That underperformance can be very significant and can sabotage long-term financial goals.

At Sigma Point Capital, we use a different approach called Performance Based Investing, in which we tactically adjust portfolio allocations based on how the economy and financial markets are doing. Once we’ve determined which asset classes are expected to outperform, we diversify our investments in those particular asset classes, but do not invest any portion of the portfolio into other non-correlated asset classes that have negative expected returns.

We’ve found that this approach allows for more targeted investing, and vastly eliminates the performance drag associated with maintaining exposure to underperforming asset classes.

Famed investor Warren Buffett once said, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” We think that’s a bit harsh, but the essence of what he’s saying is correct, and investors would do well to heed this advice.

If you don’t know what you’re doing, then by all means diversify, diversify, diversify. But if you understand how different asset classes and investments perform based on changes in the business cycle, then consider focusing your investments in the areas of the market that you expect to outperform.

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Investment Model Disclosures


Sigma Point Capital, LLC (“SPC”) is a Registered Investment Advisor. All information provided herein is for educational purposes only and does not constitute investment, legal or tax advice, an offer to buy or sell any security or insurance product; or an endorsement of any third party or such third party’s views.

Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.

All examples are hypothetical and designed solely to convey information about our investment philosophy and strategies. Investing involves a great deal of risk including the loss of some or all of your investment. Past performance is not an indication or guarantee of future performance and Sigma Point Capital does not warrant or guarantee any minimum level of investment performance. No representation is being made that any SPC client account will or is likely to achieve profits or losses similar to those shown in the hypothetical back tested performance.

Backtested Performance Disclosure Statement

Hypothetical performance shown on the Sigma Point Capital website (the “Site”) is backtested and does not represent the performance of any account managed by Sigma Point Capital. The hypothetical performance depicted was achieved by means of the retroactive application of investment strategies that were designed with the benefit of hindsight.

Backtested performance is NOT an indicator of future actual results. Hypothetical results have inherent limitations, particularly that the performance results do not reflect the results of actual trading using client assets. Additional limitations of backtested performance include, but are not limited to, the effects of material economic and market factors on the decision-making process, and the ability for the security selection methodology to be adjusted until past returns are maximized.

The performance of any account managed by Sigma Point Capital will differ from the backtested performance shown on the Site for a variety of reasons, including without limitation the following:

  • Sigma Point Capital may consider from time to time one or more factors that are not accounted for in the models, or it may not consider any or all of such factors. The inclusion or exclusion of such factors may cause Sigma Point Capital to override the model’s recommendations, which could result in performance that is higher or lower than shown.
  • The hypothetical backtested performance results assume full investment, whereas an account managed by SPC may have a positive cash balance upon rebalance. Had the backtested performance results included a positive cash position, the results would have been different and generally would have been lower.
  • The backtested performance results for each strategy are based on the daily closing prices of each security. Accounts managed by SPC will rarely, if ever, be able to transact at the exact daily closing prices, and as a result, security purchases and sales may be at higher or lower prices than those depicted in the model’s returns. This could result in performance that is higher or lower than what is depicted on the Site.
  • The timing of trades and transactions in an account managed by SPC may differ from the timing of trades and transactions shown in the backtested performance. This could result in performance that is higher or lower than what is depicted on the Site.
  • Hypothetical performance includes the reinvestment of dividends and interest, but no management fees or transaction costs are included. If management fees and transaction costs were included, the results would have been different and generally would have been lower.
  • Hypothetical performance does not reflect the impact of taxes on non-qualified accounts. If taxes were included, the results for non-qualified accounts would have been different and generally would have been lower.
  • Accounts managed by SPC are subject to additions and redemptions of assets under management, which may positively or negatively affect performance depending on the the timing of such events in relation to market conditions.
  • Simulated returns may be dependent on the market and economic conditions that existed during the backtested period. Future market or economic conditions can adversely affect the returns shown.

Performance results have been compiled solely by Sigma Point Capital, LLC and have not been independently verified.

3rd Party Data

Sigma Point Capital relies on third-party data sources for portions of its data. The information derived from these sources is believed to be accurate, but no warranties or representations are made with respect to its accuracy or completeness.

Neither Sigma Point Capital nor any third-party data provider are responsible for any damages or losses arising from any use of this information.

Fund Ticker Symbols and Definitions

In order to help existing and prospective clients understand the performance characteristics of the SPC Tactical Investment Models, backtested performance on the Site is shown in relation to three benchmarks: The S&P 500 Index, The U.S. Aggregate Bond Index, and a 60/40 blend of those two indexes (benchmarks are shown using Exchange-Traded Funds which track each index).

Sigma Point Capital Tactical Models use a combination of equity and fixed-income ETFs to achieve their results; therefore, these benchmarks provide a reasonable example of the performance that one would achieve from a buy-and-hold approach using a similar set of securities.

SPY represents the SPDR S&P 500 ETF. It is an exchange-traded fund designed to track the performance of the S&P 500 Index. It does not represent the index itself.

AGG represents the iShares Core U.S. Aggregate Bond ETF. It is an exchange-traded fund designed to track the performance of the Bloomberg Barclays U.S. Aggregate Bond Index. It does not represent the index itself. The inception date for AGG is 9-22-2003. As a result, in our analysis and backtested performance, we use price data for VBMFX (the Vanguard Total Bond Market Index) as a proxy for AGG price data for all dates prior to 10-01-2003, at which point we switch to using actual AGG price data.

"60/40 Stocks/Bonds" refers to a hypothetical portfolio that would have kept 60% of its assets invested in SPY - the SPDR S&P 500 ETF and 40% of its assets invested in AGG - the iShares Core U.S. Aggregate Bond ETF.



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