Don't Trust a Pie Chart to Test Diversification

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As we approach the end of yet another incredible year of market gains, investor confidence sits at the highest it has been in 17 years, according to the recently released Investor and Retirement Optimism Index.

It is hard not to be confident, considering the S&P 500 index is up almost 300% since its low point back in March 2009. Even more incredible is the fact that 2017 has been the least volatile year in over 50 years.

But with confidence also comes complacency … and now is definitely not the time to be complacent. I meet with investors every day and ask some basic questions to identify whether I can provide any value to the current situation.

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“What is your current strategy to help mitigate investment losses?”

“Can you show me some specific examples of diversity within your portfolio?”

“What is the maximum loss of money you can tolerate at this point in your life?”

These are just a few examples of how I learn about potential client priorities as well as the missing elements in their existing plans. Most investors point to a “pie chart” found on the first few pages of their quarterly statements. Sometimes they have several statements from several different companies, each with their own pie chart.

The Pie Chart Problem

What do all those slices of pie really mean? Do more pies, and more slices, imply greater diversity?

It is important to understand that diversification isn’t designed to boost returns. Unfortunately, for many investors, the pie chart can be misleading. The goal of “diversification” is to select different asset classes whose returns haven't historically moved in the same direction and to the same degree; and, ideally, assets whose returns typically move in opposite directions. This way, even if a portion of your portfolio is declining, the rest of your portfolio is more likely to be growing, or at least not declining as much. Thus, you can potentially offset some of the impact that a poorly performing asset class can have on an overall portfolio. Another way to describe true diversification is correlation. We want to own asset classes that are not directly correlated.

Unfortunately, even though a pie chart may make it look like an investor is safely diversified, it’s probably not the case. They are probably much more correlated to the market than they realize. Making matters worse, investors with multiple different families of mutual funds often own the exact same companies across the different families. We call this phenomenon “stock overlap” or “stock intersection.” You may own 10 different mutual funds, but the largest holdings in each fund are the same companies.

There was a fascinating study done in the late 1970s by Elton and Gruber. They concluded that a portfolio’s diversity stopped improving once you had more than 30 different securities. In other words, increasing from one or two securities up to 30 had a big improvement. Increasing from 30 all the way up to 1,000 different securities didn’t materially improve the portfolio’s diversity.

Consider that the next time you open up your quarterly statement. How many mutual funds do you really own? How many individual stocks are inside all of those mutual funds?

The Problem with the Stock-Bond Solution

Most investors attempt to mitigate risk by allocating a portion of their portfolio to equities and a portion to bonds. The “60/40” allocation, with 60% in equities and 40% in bonds, has been popular for decades. Unfortunately, according to Morningstar, over the past decade a 60/40 portfolio has a .99 correlation to a 100% equity portfolio.

In other words, the bond portion dilutes overall returns while providing little to no diversity. When you take into account we are in a rising interest rate environment, the 60/40 allocation makes even less sense.

How about overseas? Again, Morningstar data shows that back in the 1980s there was a low correlation (0.47) between U.S. equities and international equities. That correlation has steadily increased to 0.54 in the 1990s all the way up to 0.88 in the 2000s.

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So, What Do You Do Instead?

If we can’t use bonds or overseas equities to diversify, what can we use?

Portfolio diversifying instruments (PDIs) provide actual asset class diversification by reducing correlation to the stock market.

What are some examples of PDIs?

Private equity. Some non-traded real estate investment trusts offer durable distributions with low volatility and low correlation.
Private debt. Some non-traded debt investments offer high yields and a hedge against rising interest rates. Many are secured with an asset to protect against default.
Interval funds. Registered as a mutual fund, these investments can be purchased daily and sold at the end of each quarter (hence the term “interval” fund). These offer distribution rates in excess of 5% with very little downside participation.
Some annuity solutions. Index annuities provide principal protection and guaranteed rates of return as well as low fees.

Instead of taking 40% of your life savings and investing in bonds that seem to be paying less and less and are still at risk to interest rate hikes and defaults, we prefer to invest in asset classes that thrive in a rising interest rate environment. Real estate is an example of one of these asset classes, and there are more ways to access real estate than ever before. In fact, according to a recent PricewaterhouseCoopers (PwC) forecast, investments in PDIs will more than double by 2025. If accurate, this can present an incredible opportunity for some investors if they want to truly diversify.

The biggest challenge for most is finding an adviser with extensive experience working with various PDIs. If your portfolio is market based, and you are hoping your “pie chart” is going to save the day, now is not the time to be complacent. As 2018 gets underway, dedicate some time and meet with an independent financial adviser with experience working with all asset classes.

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Ronnie Blair contributed to this article.

Securities offered through Kalos Capital, Inc. and investment advisory services offered through Kalos Management Inc., both at 11525 Park Woods Circle, Alpharetta, Georgia 30005, (678) 356-1100. Verus Capital Management is not an affiliate or subsidiary of Kalos Capital, Inc. or Kalos Management, Inc. This material is educational in nature and should not be deemed as a solicitation of any specific product or service. All investments involve risk and a potential loss of principal.

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The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Mike Haffling is president and founder of Verus Capital Management in Chicago. Mike is an Investment Adviser Representative and insurance professional. He has always worked as an independent financial adviser, serving his clients with a comprehensive approach to retirement planning for more than a decade.