To Protect or To Diversify

eggsIt’s easy to confuse the benefits of diversification with downside protection. Recently a client asked how a diversified portfolio could be down relative to just buying the S&P. I actually get that a lot. When a portfolio is diversified there seems to be an expectation that somehow it should act directly in line with the S&P, just with smaller movements. However, that’s simply not the case.

For a moment, let’s consider how we might have a different experience in a portfolio with two positions in it, rather than just one. Portfolio #1 might just have the US stocks. Portfolio #2 might have two positions: US stocks and international stocks. Portfolio # 2 is more diversified, which means that it must be “safer,” right? Actually, diversification tends to remove the highs and lows over time. It might also have a better risk versus return comparison, but at times, it might have lower lows or higher highs than just one position in the S&P.

How can this happen? If US stocks go through a relatively stable period, and international bounces along differently, the international position will push the portfolio around up or down. When it moves opposite to the S&P, you will see a smoothing out of returns, but it could just as easily accentuate returns. It doesn’t mean that diversification doesn’t work, it just means that each position trades back and forth depending on who is smoothing out who. Most importantly, over time, a more diversified portfolio will generally have less average volatility. Of course, diversification and asset allocation strategies do not assure profit or protect against loss, but smooth sailing is always our goal at Eagle West.

Most of our model portfolios are broadly diversified with not just internationally, but also other asset classes, including preferred stock, high yield bonds, managed futures and sector funds like health care. So far this year, while the S&P has been relatively stable, some of the positions like managed futures and some international exposure have generally been down. We keep these diversifiers for the day when large US stocks are not the place to get returns. These positions have a tendency to “mean revert,” which means they tend to lose for brief times and win for brief times, coming back to a “traditional” price range. Right now some are on the negative side of their price range.

Pure diversification is different from the “Protect” in our Advance and Protect Model (APM). This model is designed to reduce risk by selling bad bets. By doing so, it limits a single positions ability to injure returns. That position might still cause losses, but we have a process designed to systematically limit those losses and remove the position.

Keep in mind the risk we should be concerned about is not the choppy sea, it’s being absorbed by the sea … to stretch an analogy. We have lots of planned ways to keep all our ships strong, and seaworthy; for example hedging, diversification, alternatives, layering, depending on the model and strategy we helped pick for you. Focusing on watching one index to measure success is like focusing on the churning ocean beneath you. Instead, look farther out on the horizon…if for no other reason than to avoid the queasy feeling of volatile waters.

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