Does It Pay to Diversify?
By Chris Shipman, 1st Global investment management solutions analyst II
The future is unknown – that is the reality of investing.
It may appear to be an obvious statement but investors often fail to appreciate the uncertainty that they face. Many of the recent financial market disasters and massive loss of wealth point directly to investors believing that the future was more certain than it turned out to be.
One way we can help our client investors possibly avoid these financial catastrophes and achieve greater returns with less volatility is to encourage them to diversify their portfolios properly. The notion of diversification isn't new but clients don't always have the knowledge of how to diversify. What many clients miss is a clear understanding of how they should approach the diversification process.
The Diversification Process
As a knowledgeable advisor, it is your responsibility to guide your clients through this process. Utilizing the well-known investment approach of Modern Portfolio Theory (MPT), advisors can incorporate their clients' beliefs and convictions about the future into better investment decisions, strategies and practices.
The act of diversifying a portfolio is much more than simply adding more securities. There is a "right kind" of diversification that provides the "right reason" for adding additional securities or asset classes to a portfolio.
Your clients' beliefs are at the core of the portfolio selection process. It is important then to understand that the process represents not only a diversification of assets or asset classes, but also a diversification of the beliefs regarding the expected returns and risks of those investments or asset classes. We must provide the necessary resources to help clients understand their preferences or tolerance for risk while respecting their beliefs.
Every client is unique in their willingness to bear risk, which means clients have a unique utility function. They don't always have a way to understand or compare the uncertainty presented by those investments, which means risk is always a fairly undefined concept they have to accept in pursuing returns. Often, clients fail to consider uncertainty in their investment decisions and have developed unrealistic expectations around the returns that could be achieved.
You should begin with risk assessment processes that guide clients through a carefully selected set of questions to assess their preferences for risk and return. This information and a conversation explaining the results/preferences can then be used to provide a recommendation of an investable portfolio which seeks to maximize their expected utility. By working with clients through a thoughtful application of their beliefs about the future, advisors can develop a strategy designed to maximize expected returns based on the risk clients are willing to accept.
Important Steps to Diversifying a Portfolio
1) Assess and help clients understand their preferences or tolerance for risk
2) Don’t forget to consider the client’s uncertainty about risk to prevent unrealistic expectations from developing
3) Use the assessment and conversation to provide a portfolio recommendation that seeks to maximize their expected utility
4) Clarify that no diversification strategy can eliminate all risk of investment losses
Rather than looking at diversification at the individual security level, diversification needs to be viewed at the portfolio level. If clients are attempting to diversify the first security they owned with a second, then the third security purchased needs to consider not only the first, but also the second. As additional securities are added, so does the complexity of the decisions advisors and their clients have to make.
The MPT process of identifying efficient portfolios begins with a selection of asset classes and continuing through the development of expectations based on beliefs. By developing model portfolios, as well as deliberate application of discipline and process to every variable and portfolio implementation, the portfolio maintains efficiency over time. In identifying a specific set of model portfolios, advisors can provide sound investment guidance firmly based on rigorous academic and intellectual standards.
Advisors can then work with clients to build a diversified portfolio made up of securities representing various asset classes that provide the greatest expected return for each level of expected risk and then select from these portfolios.
Diversification acknowledges that we do not know what the future will truly offer. It is also important to keep in mind that diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses. However, seeking portfolio efficiency through the methods above is the best use of what we do know about how the world works for our clients.
Chris Shipman serves as an IMS Analyst for the 1st Global Investment Management Research Group, where he provides ongoing research and recommendations on asset allocation, rebalancing parameters and manager selection for the company's managed portfolios.
1st Global Capital Corp. is a member of FINRA and SIPC and is headquartered at 12750 Merit Drive, Suite 1200 in Dallas, Texas 75251; (214) 294-5000. Additional information about 1st Global is available via the Internet at www.1stGlobal.com.