Diversification — Is it Bunk?
Investment houses espouse an investor’s portfolio should be fully invested at all times and allocated across multiple asset classes; domestic stocks (large-cap, mid-cap, small-cap), foreign, commodities, emerging markets, bonds, etc…
Below is an excerpt from one of the biggest investment companies,
“The goal of diversification is not to boost performance but to help manage risk. Diversification doesn’t ensure a profit or guarantee against a loss. And while it won’t maximize returns in up markets—in fact it will likely reduce them—it can help you ride out swings in the market, because as one part of your portfolio struggles, another may be performing well. That can be very important, particularly for people in or nearing retirement who depend on their portfolios for income.”
From 2000 to present, major market index returns are nearly flat. During the market crash in 2008, investments of all asset classes suffered major losses; stock funds, corporate-bond funds, real-estate stocks, commodities. One important measure of the broad market index is the S&P500. The S&P500 declined by nearly 56% in 2008. The simple math is that for an investor to break even from a 50% decline, he would need to gain 100%. A chart of the S&P500 (courtesy from Doug Short) depicts the timeframe from March 24, 2000 to the present. It shows $1,000 invested in the S&P500 would be diminished in value to $812 as of 1/31/2012 when adjusted for inflation.
An unspoken secret of investment company ‘s is that fees are collected by the investment of assets. As an economy of scale, the more assets under management actively invested, the more fees collected. A managed account typically charges somewhere between 1%-to-3% per account. A $1,000,000.00 account generates $10,000-$30,000 in revenue. Multiplied by many accounts one can see that this fee is substantial. This fee is charged regardless of whether an investor makes or loses money in any given quarter or annually. During the 2008 market collapse, managed fees from one ‘s portfolio would further decrease the principal balance of the account.
Some major brokerage institutions during the recent 2008 housing debacle, were trading against the customers whom they were advising. One large institution was accused of overcharging for two sets of mortgage-backed securities that it sold to a hedge fund client. This institution was accused of lying about the securities’ expected performance; not providing timely, accurate information about the securities’ true value; and failing to disclose that the firm was actively betting against the securities at the time of the transaction
Based on the past decade, we have learned that world stock markets become more inter-related and that changes in one country/market will have a ripple effect across all other markets. Additionally, the rise of ETFs (Exchange Traded Funds) that bundle stocks together coupled with the depedence on leverage forces fund managers to liquidate positions quickly to cover losses. Institutions have also increased usage of High Frequency Trading contributing to stock market volatility.
An example of this market dependency is the 2008 US housing crisis. During this period, the U.S. housing market not only affected the US market, but it also brought down major institutions around the world. Case in point, before the 2008 collapse and the general financial crisis, RBS Group was very briefly the largest bank in the world and for some time was the second largest bank in the UK and Europe (fifth in stock market value), and fifth largest in the world by market capitalisation. Subsequently, with a slumping share price and major loss of confidence, the bank fell sharply in the rankings and had to be rescued by the UK government. Lehman Brothers Holdings Inc. , the fourth largest investment bank in the USA (behind Goldman Sachs, Morgan Stanley, and Merrill Lynch) declared bankrupcy in the fall of 2008.
Since 2000 (aka, the lost decade), the 2000 – 2002 dot bomb, the 2008 Financial Crisis, Euro-quake, the Flash Crash, Flash Trading in general, Dark Pools; the average investor may be left with the feeling the game is rigged. As a result, investors have withdrawn a record amount of money from mutual funds as the market lurched from one event to another. Based on a recent note from the venerable Investment Company Institute, a staggering $75 billion has been withdrawn from equity mutual funds.
Recommendations:
What ‘s an investor to do in this time of uncertainty? As one of the greatest investors of our generation Warren Buffet stresses “Capital Preservation”. He is famous for his 2-rules; Rule No. 1 “Protect Your Capital” and Rule no. 2 “Go Back and See Rule no.1”.
We recommend one should invest based on the current economic cycle and NOT be fully-invested at all times as preached by the investment companies. By investing based on the business cycle, investors are likely able to produce better average returns. This approach also helps long-term investors to identify when to buy or sell. Click here for the link to “Sectors and the Business Cycle: A Primer” by Bob Johnson for additional details.
In times of major economic uncertainty, “capital preservation” is key to one ‘s portfolio and cash or short-term money markets are best to preserve capital while waiting for better opportunities.
SmartMoney posted an article title “A 60-40 portfolio split may not work” which agrees with our views. Click here for the link
http://www.smartmoney.com/invest/strategies/why-a-balanced-portfolio-may-not-work-1337101197387/?link=SM_hp_ls4e