Diversification can be flawed

Managing other peoples’ money is about choosing the right investment approach and the right colour of lipstick or tie—red ties win more frequently. Investors are poor arbiters of good and bad portfolio management and too reliant on past returns. They’re forced by the industry to value relative performance and they’re faced with conventional portfolio approaches that don’t help. To paraphrase the plight of a diversified investor from James Osborne’s essay “Diversification Sucks”:

• Your portfolio will always seem to be mediocre, because returns will be worse than the best performing asset class.
• Your portfolio will be worse than the popular stocks of the day, like Apple or Netflix.
• You always hate something in your portfolio. Emerging markets or commodities are examples of underperforming groups in recent years.
• You never own enough of the things that are doing well—U.S. large cap and technology, for example.
• What you like in your portfolio today will turn on you quickly, and you’ll hate it tomorrow (i.e., international equities before the crash).

1.2%

The percentage by which sales of existing U.S. homes rose in February.

Source: National Association of Realtors

The consequence, according to Osborne, is a persistent feeling of dissatisfaction with your current asset allocation or issue selection, which promotes tinkering, trading and performance chasing. But if you do those things, there’s one certainty: trading costs will go up.

For advisors, these characteristics ring true because clients often don’t care about their performance. Investors care about somebody else’s performance—they’ll tell you about a relative or neighbour who only talks about their investments when they do extraordinarily well, or a portfolio manager in the media who only talks about her winners. Institutional portfolio managers are not immune to this phenomenon. It’s called window dressing, and is a discouraged practice often associated with driving prices of large holdings higher to inflate valuations, selling losers so they don’t appear in the portfolio at quarter’s end, or buying the best performers so that they do. Institutional money management mandates are often awarded to firms with current first quartile returns because nobody gets blamed for hiring a manager with good performance. The problem is maintaining that performance.

Investment management

The time to establish expectations with clients is when performance is great. Providing explanations when markets are in the middle of a sharp decline is almost always too late. But there is an alternative that comes from decision theory.

Decision theory (DT) works like the logic of a GPS system. It cares less about speed and more about direction. Technically, DT cares about minimizing losses, or about moving toward a goal by not moving away from it. The chart “Retirement savings” (this page) provides an example related to retirement savings.

An investor’s target capital establishes a capital accumulation path (the blue dotted line). Reacting to actual experience, rather than rebalancing to a fixed asset mix, is logical. When behind the path (A and C), you take more risk and, when you’re ahead, (B) take less. The only performance measurement that matters is the distance from the path, not some other fund or advisor.

Here’s how it works in practice. The CIO, CEO and board of a $45-billion Australian defined contribution pension plan decided to convert their 525,000-member plan from mutual funds to one that followed a decision theory approach. The executives stopped listing the performance of their funds in the media; so, comparison to benchmarks and other funds became irrelevant because the only thing that mattered was how plan members were progressing toward their goal. Most advisors manage portfolios to a benchmark related to an investor’s goals, risk tolerance and time horizon. But their relationship with the benchmark, like 60% equities and 40% bonds, is often tangential.

Historical returns are used to project future returns. This is fine if future returns reflect those in the past, but using historical returns presents a problem. Who, for example, believes interest rates will continue to decline for the next 32 years, as they have in the past?

Using decision theory, diversification becomes a tool, not a measuring stick. Benchmarks can still be used to illustrate comparable capital market returns, but relative performance is not much good to investors. Real dollars are what people spend, not relative ones.

by Mark Yamada, president of PUR Investing Inc., a registered portfolio manager and software development firm. Disclosure: PUR Investing Inc. sub-advises for, and provides risk-based model portfolios to, Horizons ETFs.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.