“Studies have shown that more money is better than less money.”

       – Bart Wagstaff, a quick-witted Capita advisor.

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More is usually better however, just as you will get sick with too much ice-cream in one sitting, so will your portfolio with too much diversification.

Diversification is good. The black line is 5 well known stocks together as one portfolio. The other colors are each of the 5 stocks individually. Notice how much less the black line moves up or down. This is both the benefit and the demise of diversification.

If diversification is good, how can too much be bad? At some point additional diversification becomes worthless and you are paying for it.

In the real world, we all have a risk budget. Your risk budget is how much risk or volatility we are willing to experience. Usually our risk budget is more of a feeling. For example, the value of your portfolio declines enough that you say, “I’m done!” You just found the size of your risk budget. Portfolio managers often purposefully restrict their strategy to a risk budget measured through some combination of volatility metrics. This is helpful. You are less likely to overspend your risk budget if you know in advance the risks the manager might take.

The Capita Investment Contest

Throughout the summer of 2019, Capita is holding an internal investment contest for employee training and engagement. I wanted our team members to experience the feelings of using a “risk budget” to construct a portfolio. It is what we expect our third-party portfolio managers to do. Risk budgeting is something you should understand as an investor.

I started with these rules:

1) A maximum of 5 securities

2) Investments must trade on the Nasdaq or New York Stock Exchange.

3) The portfolio standard deviation needs to be less than 16%*.

To level the playing field between our practicing advisors and the rest of our staff, all ETFs, shorting, and leverage was excluded. There was an audible groan from the advisors with that announcement.

The contest will run through the summer months of June, July, and Aug of 2019. At the end, the top three winners will share $1,000 worth of prize money. Mike, our founder, threw in a $100 kicker for anyone who beats him.

This hands-on exercise has provided meaningful investment training for the staff.  

We are “improving lives, one financial decision at a time” internally as well and I love it! Every team member has had to feel the difficulty of investment fitting within a risk managed portfolio.  

Based on the name of each portfolio you’ll notice that I am having way too much fun with this.

If we had started the investment contest at the beginning of 2019 running until now, the following chart would be the results. (thick black line is the S&P 500)

We have 4 who have purposefully built a defensive strategy. If the market is down over the summer, one of them will win. Notice how three have under-performed the S&P 500 in this positive-returns environment. If we see a downturn, they might be the only ones who beat the S&P 500. The rest have tried to maximize their return using their full 16% standard deviation “risk budget” to do well in a positive market.

The employees’ portfolios which were not positioned defensively showed excess returns over the S&P 500 for the first 5 months of 2019. I can’t help but wonder if this strong performance could be attributed to two possible reasons.

1) Hindsight Investing.

2) Concentrated Portfolios.

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Hindsight Investing

This is when you pick investments that have done well. It looks great in the rear-view mirror, but that is not a safe way to drive a vehicle forward.

A contrarian investor would rather buy investments that have done poorly assuming a reversion to mean will cause their portfolio to do well in the future. This is like catching the roller coaster at the bottom and riding it up.

A momentum investor would buy those investments that have done well recently assuming there is a wave to ride that will continue to flow.

There are professional investors who succeed at a contrarian or momentum strategy, but rarely both in the same fund/manager. Diversification of philosophy is important. You may decide to include multiply philosophies, however, don’t expect one strategy to be both at the same time.

Concentrated Portfolios

If you ARE the market, you cannot BEAT the market. This seems simple enough, but you normally don’t know when you ARE the market.

Let’s talk about cost. You may be paying for financial planning services. The financial planning cost is to ensure you and your advisor make good decisions involving categories including and beyond investment management like taxes, estate planning, cash flow strategies, savings rates, and major life transitions.

Whether or not you have a planner, you are paying for someone’s investment knowledge or access to securities. Investment costs are often embedded in the investment solutions as expense ratios. If you are so diversified that you ARE the market, yet you are paying professionals to try and BEAT the market, you are paying for active management without a chance at active returns.

Take a stance. Either BE the market or attempt to BEAT the market, but don’t pay a fund to BEAT the market and then end up BEING the market.

MarketWatch has a list of the top 25 mutual funds by assets under management. There are only two actively managed funds on the list, the rest are index funds. Active funds typically transact more often and charge a higher fee for management called an expense ratio. Expense ratios are only a portion of the cost of investing in funds. Listen to The Financial Call episode with Kurt Brown on Model Delivery for more information about this.

Let’s look at these two actively managed funds that are listed in the top 25 in terms of assets under management. One of these funds has 299 positions and one has 296 positions. Many funds are pushing 500+ positions so nearly 300 is relatively low. The S&P 500 has 505 names in it. If you own just a couple funds, how different are you than the index? There is a term for this scenario: “Closet Indexing”. You pay an expense ratio of 0.5% to 1.5% for what you could have gotten in an index fund for 0.05%. The other option is to buy the underlying stocks directly with no expense ratio. This involves a lot less turnover and trading which is more efficient.

I audited a portfolio recently that had over 500 mutual funds. If the average fund has 300-400 positions—which is low—that portfolio has 150,000 to 200,000 lines to the underlying positions in those funds. The account was less than $500,000. This is less than $4 invested per underlying position. For relative reference, the New York Stock Exchange only trades roughly 3,000 stocks.

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Diminishing Diversification Benefit

You’ve heard that diversification is good, for example, at the beginning of this article when I said, “Diversification is good”. In the early stages of portfolio construction, the diversification benefit is massive. However, it diminishes quicker than you realize.

To teach risk budgeting, my team needed some measurement to assess risk. There are many sophisticated ways of doing this—Beta, Treynor, Sharpe, downside capture—however, to keep it basic, we chose standard deviation (SD). SD is just a measurement of variation. It answers the question: How much will the returns of this portfolio vary?

Standard Deviation can feel like a magician pulling slight-of-hand tricks on your mind.I purposefully chose 5 well known stocks that have an incredibly tight range of SD. The average is 17.8%. The range is 17.7% to 17.9%.

One would think, “If the average variation in each stock’s returns is 17.8%, then the average variation in my portfolio must also be 17.8%.”

The magician hands are waving…it’s 11.9%.

Since these 5 stocks (although very similar in the amount of variation) move up and down based on different factors, the variation of the group as a whole is less than the parts.

Perfect, we proved that diversification is good, just like ice-cream, but when do you get sick?

The next chart shows the SD as you add each stock to this portfolio. The average SD is blue, the actual SD is Orange. Look at how much the SD dropped upon adding the 2nd stock! Now compare that with adding stock number 5. The SD decrease by adding the fifth stock is barely noticeable.

Admittedly, we have selected 5 stocks from a similar category, however, most people have hundreds of stocks in each category. Adding Stock #5 reduced SD from 12.2% to 11.9%, a difference of 0.3%. How much benefit are you really getting with stock number 3,951 in your funds? Instead of “let’s properly diversify your portfolio”, I would like to say to my clients, “let’s properly concentrate your portfolio”. It is a strange concept, but hyper-diversification has become the emperor’s new clothes.

My team’s personalities are beaming through their stock selection. They learned that you can take 5 highly volatile stocks and get the portfolio down to a 16% standard deviation. They also learned they need to beat Mike to earn $100. Luckily, Mike built one of the 4 defensive strategies which is completely opposite to his personality. Most of us will walk away with a cold Benjamin if we can count on that 70% of months being positive.