Remembering Diversification in Investment Planning


The very hallmark of suitability is diversification. To uphold the fiduciary duty of implementing only suitable investments, the broker must avoid over-concentration at all costs in favor of a diversified portfolio. The more aggressive the objectives of the investor, the more necessary it is to diversify the investor's assets to mitigate the risk.

Diversity in Investment

According to the Prudent Investor Principle, diversification is essential to prudent investing. One of the time honored investment maxims is that risk can be reduced by diversification. The Nobel Prize for Economics was awarded to Harry Markowitz in 1990 for a rigorous explanation of this principle. There is general agreement that a portfolio of investments is truly diversified only when it is made up of distinctly separate and broadly different asset classes. In my opinion, it takes at least 50 stocks, spread among five usually six non-correlated asset classes to achieve adequate diversification and thereby reduce non-systemic risk. This is basically firm-specific risk – the risk of one company causing a significant move, either up or down, in a portfolio (Modern Portfolio Theory – Edward Elton & Martin Gruber – 1987).

Even index funds alone do not assure that the diversification requirement is met. In recent years, a handful of stocks have moved the S&P 500, and, even more, the NASDAQ Composite Index. In 1998, the top five stocks contributed 25% of the S&P 500 performance and 70% of the NASDAQ; the top stocks contributed 41% and 82% respectively! These are not broad cross-sections of American industry, as was the case as recently as 1995, when the top ten stocks in the S&P 500 only contributed 13% of the performance.

To obtain real diversification today, international assets along with the Russell 2000 should be considered as well. To achieve diversification internationally, one need not look to foreign stocks alone. American companies, as of the year 2000, with their percentages of foreign earnings included; AIG (53%) Coca-Cola (82%), Gillette (63%), Intel (58%), Microsoft (37%) and Pfizer (49%).

William Sharpe, another Nobel Prize winner from Stanford University and creator of the Sharpe Ratio wrote in 1978, "Diversification does reduce risk, and the reduction can be greater, the wider the range of possible investments".

The duties increase for the broker as fiduciary. A fiduciary may invest in many things but he should not gamble. Gambling may be defined as buying an asset without an inherent, ascertainable underlying buildup of value through earnings or interest.

It is clear that a fiduciary must diversify unless it is clearly "prudent" not to! In the absence of specific authorization to do otherwise, a conscious concentration and lack of diversification would constitute a serious breach of fiduciary obligation. Further, breach of this duty to diversify constitutes an independent basis of liability, separate from the breach of the general duty of prudence (Liss v Smith, 991, F. Supp. 278,301 (SDNY, 1998).

Diversification, then, is uniformly acknowledged to be a pre-requisite of a well managed account. Anything that deviates from this expected treatment of a customer must be justified by the broker. The decision to concentrate a portfolio in only one asset class, and not diversify, must be fully grounded in the broker's due diligence and research, into (a) the portfolio design and (b) the specific securities selected. It is not sufficient simply to have a reasonable basis for recommending a concentration of securities in only one asset class, rather the broker/fiduciary must also have reasonable grounds for deviating from the norm of prudent investing!

If a broker/fiduciary chooses to select securities where there is a conflict with his own firm i.e. proprietary products, the required justification is greater. The broker must make a reasonable determination that because of "special circumstances" it is prudent not to diversify. Note that the test is prudence, not whether the broker thinks he can make more profits by not diversifying, but whether it is more prudent to forego the protection and risk diminution afforded by diversification. Note also, that the language "reasonable determination" implies an objective standard, not the subjective opinion of the broker. For a fiduciary, then, the threshold is even higher. A fiduciary must have a compelling reason not to diversify i.e. it must be "clearly prudent not to do so".

Furthermore, prudent investment management is evaluated on an ongoing basis. Even if the broker may have had reasonable grounds at the outset, retaining the investments and increasing the concentration may become imprudent later. True diversification does not promise that the portfolio will outperform the market, only that it will be intelligently designed for the investor's financial circumstances and well being.

Reducing Risk Through Diversification

Historically speaking, with the tremendous returns of the S&P 500 during the mid-90's, one would have been hard pressed to encourage investors to venture away from the rampaging stock market. However the technology crash in the NASDAQ and the recent two year double digit downturn of the S&P 500 has caused investors once again to turn their attention to diversify their portfolios. Investors now want to reduce their risk and lower their concentration in technology at all costs.

Exhibit A illustrates the compounded annual returns from 1970 through 1990 in various asset classes. Surprisingly, the average annual return on stocks and the return on the five asset class diversified portfolio is identical at 11.2%. However, the number of years with positive returns is 17 vs. 15. Most interestingly, look at the recession years of 1973 and 1974. The investor would have lost 41% in the stock only portfolio. He, most probably, would have "left the game" and liquidated his investments. Look at those same years in the diversified portfolio. The total return was only a blip – down 8.8%. This investor would have, most probably, remained invested and not panicked or fled.

But that was a long time ago. Let's look at the current picture. Exhibit B shows the compounded annual returns between 1981 and 2003 in five various portfolio mixes. At first blush, one would feel justified for having ventured only into the S&P 500 for the last 23 years. But take a closer look at the five asset class diversified portfolio in column five. Compared to column one, there were 21 years of positive returns instead of only 18. In other words, the investor was able to sleep more comfortably for three more years. During the four year period from 2000 through 2003, the investor in stocks only would have lost nearly 16% of his capital. However, during that same four year period, in the diversified portfolio, the account would have gained 21%!

Further, the diversified portfolio over the entire 23 years under performed the 100% stock portfolio by .69%. Notice the level of risk by comparison. The S&P 500 had a standard deviation of 16.24% over the period compared to only 7.44% for the diversified portfolio, less than half the level of risk. Standard deviation is a measure of volatility indicating the amount by which most of the returns varied around the average. The higher the standard deviation, the greater the volatility and thus the greater the risk. For example, a standard deviation of 10% indicates that most (two-thirds) of the actual returns over a particular time period varied around the average return by plus or minus 10% - in other words, if the average return was 17%, most of the actual returns ranged form 7% to 27%.

With the graying of America , investors are continually looking for returns and results that they can rely upon, on a continuous basis. A diversified portfolio in five non-overlapping asset classes helps provide that probability of verifiable consistency.

Finally, in the late 90's, investors strayed far from the S&P 500 and implemented large positions in the tech-heavy NASDAQ to their detriment, incurring losses in excess of 70% between the years 2000 through 2002 with this overly aggressive and speculative concentration.

As shown in the chart, the S&P 500, which is market-capitalization weighted, was down 11.9% in 2001. However, according to James B. Cloonan, Ph.D. Chairman of the American Association of Individual Investors in its April 2002 AAII Journal, "a portfolio of the same 500 stocks equally weighted would have been up 1.63% for the year. The NASDAQ Composite Index, also market-capitalization weighted, was down 20.13% in 2001, but those same approx. 4,000 stocks bought in equal dollar amounts would have been up 63.86%! This seems incredible, but remember almost all the losses on the NASDAQ were in the high-cap. technology stocks. In contrast, micro-cap stocks (companies whose market capitalization is below $250 million) had a banner year". Further, the AAII Journal, in November 2002, reported that "over the last 10 years the Wilshire 5000 index has had an average annual return (through September 30,2002) of 8.69%. However, the return of the Wilshire 5000 unweighted by market capitalization (in other words, the average stock in the index), is 14.17% a year. And to throw in another shocker: The NASDAQ Composite index is down dramatically year to date, with a return of -39.26%, yet the average stock on the NASDAQ is up 30.54%, and the average stock has been up each year for the past three years". Actually, 37% of all U.S. stocks had a positive return in the year 2002. The average return of those stocks that did have a positive return was an astonishing 43.4%. The point about market indexes is this. Because of the dependence upon market capitalization weighting, the U.S. equity market as a whole is generally not performing as well, or as badly as the major benchmarks indicate.

While the NASDAQ Composite was and is heavily weighted with large cap tech. stocks, the S&P 500 was far less concentrated. Consider the S&P 500 concentration (by market capitalization) in technology at the following periods:

9/99

12/99

3/00

12/00

12/01

6/02

12/02

23%

24%

32%

24%

21%

15%

20%

Note: The S & P 500, by number currently has 26 telecom stocks, 19 software stocks & 15 computer related stocks, or 60 issues out of 500 for a total of 12% "technology"!

By contrast, the technology concentration in the NASDAQ Composite Index between 12/99 and 3/00 averaged 63% of market capitalization value. The technology concentration in the S&P 500 has declined steadily from March of 2000 to only 15% as reported in the Wall Street Journal on June 25, 2002, and 20% by 12-31-02. It was virtually the same for 2003.

The 12.89% return in the S&P 500 for the entire 23 year period was only available for those investors who remained there during the technology boom. Many strayed to the NASDAQ through their own greed along with that of their advisors (seeking the higher performance of dot-com and tech. issues), and they experienced necessarily a much lower compounded annual return through 2003.

Historical Portfolio Returns: 1/79 – 12/02

Stock %

Bond %

Ave. Annual Return

Portfolio Risk (Standard Deviation)

0%

100%

9.6%

6.4%

10%

90%

9.8%

6.4%

20%

80%

10.0%

6.7%

30%

70%

10.2%

7.3%

40%

60%

10.3%

8.1%

50%

50%

10.4%

9.1%

60%

40%

10.4%

10.3%

70%

30%

10.5%

11.5%

80%

20%

10.5%

12.8%

90%

10%

10.4%

14.2%

100%

0%

10.4%

15.6%

Stocks: Russell 3000
Bonds: Lehman Aggregate Bond Index

From the chart above, one can see that abandoning bonds is as foolish now as it was in 1999! Investors should note that maintaining a 30% allocation in fixed income securities cuts portfolio volatility by one-third, but with negligible upside impairment. Instead of trying to guess, we look for sound investment opportunities without correlations to U.S. stocks and combine them in proportions most appropriate to each client's investment objectives and risk/return profile. For example, the correlations between emerging market stocks and real estate investment trusts is quite low. And there's effectively no correlation between the returns on cash and the returns on U.S. stocks. You can see that the dollar, too, moves with relation to the U.S. stock market, which adds to the diversified effect of investing abroad. With the recent decline in interest rates, one has to be a bit more creative, utilizing inflation indexed bonds, convertible securities and quality high yield bonds, for example

Scorecard – Standard Deviation
(1 = best – 9 = worst)

Standard Deviation

Volatility Risk Rating

Up to 7.99

1

8.00 – 10.99

2

11.00 – 13.99

3

14.00 – 16.99

4

17.00 – 19.99

5

20.00 – 22.99

6

23.00 – 25.99

7

26.00 – 28.99

8

29.00 and up

9

As we observe the markets rebounding nicely in 2003 (up over 30% according to the VAY Index), we must remind ourselves of the valuable lesson history has taught us! In the last 23 years the five asset class diversified portfolio has performed virtually equivalent to the growth stock portfolio, but with less than half the level of risk. It will take all of our resolve to remember that historical truism.

Conclusion

The point is this: Sector sizzle will come and go just like it always has. Conversely, investors planning for retirement want their retirement funds to grow consistently with the realistic probability of controlling risk levels. A diversified portfolio does that. Once again it is "an idea whose time has come".

Exhibit A: Compounded Annual Returns for Asset Classes


Year

100% Stocks

100% Bonds

60% Stocks 40% Bonds

Stocks Bonds Cash (1/3 in each)

5 Asset Class Diversified Portfolio*

1970

4.0%

12.1%

7.5%

8.0%

4.7%

1971

14.3%

13.2%

14.1%

10.8%

13.7%

1972

19.0%

5.7%

13.5%

9.4%

15.1%

1973

-14.7%

-1.1%

-9.1%

-3.0%

-2.2%

1974

-26.5%

4.4%

-14.9%

-5.4%

-6.6%

1975

37.2%

9.2%

25.7%

17.0%

19.6%

1976

23.8%

16.8%

21.2%

15.2%

11.5%

1977

-7.2%

-0.7%

-4.6%

-0.9%

6.1%

1978

6.6%

-1.2%

3.7%

4.4%

13.0%

1979

18.4%

-1.2%

10.8%

9.1%

11.5%

1980

32.4%

-4.0%

17.5%

13.2%

17.9%

1981

-4.9%

1.9%

-2.0%

4.1%

6.4%

1982

21.4%

40.4%

29.0%

24.0%

14.4%

1983

22.5%

0.7%

13.4%

10.5%

15.4%

1984

6.3%

15.4%

10.1%

10.8%

10.4%

1985

32.2%

31.0%

31.9%

23.4%

25.4%

1986

18.5%

24.4%

21.1%

16.6%

23.3%

1987

5.2%

-2.7%

3.6%

3.9%

8.6%

1988

16.8%

9.7%

14.0%

11.0%

13.2%

1989

31.5%

18.1%

26.2%

19.2%

14.3%

1990

- 3.2%

6.2%

0.6%

3.6%

- 1.4%

Compound Annual Ret.

11.2%

8.7%

10.5

9.6%

11.2%

# of Years with Positive Returns

15

14

16

17

17

Stocks: S&P 500 Index, Bonds: Lehman Agg. Bond Index, Cash: 180 day C.D.

*Diversified Portfolio: 20% S&P 500, 20% Lehman Aggregate Bond Index, 20% Equity REITS, 20% MSCI World Index (International), 20% Cash. Assumes annual rebalancing.

Sources: Morningstar, Ibbotson, NAREIT & BB&K Index

Exhibit B: Compounded Annual Returns for Portfolio Mixes


Year

100% Stocks

100% Bonds

60% Stocks 40% Bonds

Stocks Bonds Cash (1/3 in each)

5 Asset Class Diversified Portfolio*

1981

- 4.9%

1.9%

- 2.0%

4.1%

8.7%

1982

21.4%

40.4%

29.0%

24.0%

20.6%

1983

22.5%

0.7%

13.4%

10.5%

15.4%

1984

6.3%

15.4%

10.1%

10.8%

12.4%

1985

32.2%

22.1%

28.6%

20.8%

25.4%

1986

18.5%

15.3%

17.2%

13.4%

23.3%

1987

5.2%

2.8%

4.2%

5.0%

8.6%

1988

16.6%

7.9%

13.1%

10.8%

13.2%

1989

31.7%

14.5%

24.8%

18.4%

16.5%

1990

- 3.1%

9.0%

1.7%

4.7%

12.6%

1991

30.5%

16.0%

24.7%

17.4%

18.7%

1992

7.6%

7.4%

7.5%

6.2%

5.3%

1993

10.1%

9.8%

10.0%

7.7%

12.6%

1994

1.3%

- 2.9%

- 0.4%

1.1%

2.0%

1995

37.5%

18.5%

29.9%

20.7%

19.2%

1996

22.9%

3.6%

15.2%

10.7%

15.8%

1997

33.3%

9.7%

23.9%

16.2%

16.6%

1998

28.6%

8.7%

20.6%

14.2%

9.6%

1999

21.4%

- 0.8%

12.5%

8.7%

9.0%

2000

- 9.1%

11.6%

- 0.8%

3.0%

4.3%

2001

-11.9%

8.4%

- 3.8%

0.2%

- 0.7%

2002

-23.4%

10.3%

- 9.9%

-10.7%

- 3.7%

2003

28.7%

18.8%

4.1%

11.3%

21.0%

Compound

12.89%

10.49%

11.31%

9.68%

12.20% Annual Ret.

# of Years with Positive Returns

18

21

18

22

21

Stand. Dev. Risk Levels

16.24%

9.01%

11.36%

7.76%

7.44%

Stocks: S&P 500 Index, Bonds: Lehman Agg. Bond Index, Cash: 180 day C.D.

*Diversified Portfolio: 20% S&P 500, 20% Lehman Aggregate Bond Index, 20% Equity REITS, 20% MSCI World Index (International), 20% Cash. Assumes annual rebalancing.

Sources: Morningstar, Ibbotson, Thomson Financial, NAREIT & Overlap, Inc.

About the Author: Mason Dinehart III, RFC is a national expert witness and consultant for litigation and arbitration involving securities, insurance, annuities and taxation.

Copyright © 2004 Mason Alan Dinehart III, All rights reserved. No portion of this article may be reproduced without the express written permission of the copyright holder. If you use a quotation, excerpt or paraphrase of this article, except as otherwise authorized in writing by the author of the article you must cite this article as a source for your work and include a link back to the original article from any online materials that incorporate or are derived from the content of this article.

This article was last reviewed or amended on Nov 4, 2014.