What is Diversification?

What is Diversification?

The only free lunch?

Diversification has become an accepted, foundational principle for constructing investment portfolios. In many cases, the discussion around diversification centers on incorporating multiple asset classes into a portfolio to enhance the overall risk/return profile. This is the classic approach widely adopted by most financial planners.

In our view, strategy diversification is an additional, important investment tool for constructing portfolios. It is not just what securities are owned but also how and why. In using a rules-based system, these questions are answered very precisely.

Passive diversification derives return by accepting market risk.  A traditional diversified portfolio includes stocks and bonds, often at 60% and 40% allocation.  These investments are meant to be held during all market cycles with the understanding that when one asset class is down, the other is usually up.  But the risk of passive diversification is that there have been times when this theory wasn’t true.  A passive investor must be willing to hold an investment through sustained periods of losses and portfolio drawdowns.

Tactical portfolios derive return by accepting strategy or active risk.  It is often thought of as a risk management tool with the potential to reduce volatility and protect capital. It may also offer the potential to act as a portfolio growth engine by capturing unique investment returns, such as in sector and country rotation strategies.  Tactical management offers the potential to protect against downside market risk and capture upside market returns, but it is important to recognize it will not eliminate risk. Instead, risk has simply changed form, from market risk to strategy risk.

Benchmarking tactical strategies are often difficult.

One of the most common failings of the investment industry is the prevalence of poorly specified benchmarks.

By design, tactical management looks and behaves differently than strategic, passive investment allocations. These differences are sometimes misunderstood, and the ability to effectively extract returns through tactical management requires sustained commitment. Because tactical strategies behave differently than popular investment benchmarks, it is important to determine how long and by how much an investor will allow a tactical strategy to underperform against an appropriate benchmark. A significant risk for investors that utilize tactical strategies is not that the tactical strategy does not work, but rather that the tactical strategy is inappropriately benchmarked, leading to false comparisons or expectations.

Tactical strategies that reduce exposure to underperforming asset classes offer the potential to reduce volatility and protect against significant portfolio downside.  Downside protection is essential for investors with finite horizons, as the sequence of returns becomes particularly meaningful.  It may be impossible or difficult to avoid some drawdown or losses in investment portfolios, but the potential for tactical management to cushion drawdowns may make the difference as investors attempt to weather inevitable pullbacks and market volatility.