Pitfalls of Diversification Strategies
9/22/2021
It’s axiomatic that prudent investors should hold diversified portfolios; and while I don’t disagree with this principle, I feel that this objective is too frequently misapplied. Under the guise of seeking diversification, too many people include too much garbage in their holdings.
Modern portfolio theory postulates that investors should seek to compose a mix of investments that will optimize their expected return for a given level of risk. To that effect, practitioners often add uncorrelated asset classes to the mix of investments as a way to affect this desired diversification. This intention serves as the basis for the inclusion in a portfolio of such things as gold, cryptocurrencies like bitcoin and others, commodities, and other categories that fall under the umbrella of “alternative assets.” In many cases, I believe inclusion of some of these types of assets in investment portfolios is a mistake, where promoters of these vehicles are taking advantage of an ill-informed or ignorant public.
I take issue with including any asset category in a portfolio for which the assumption of a positive return is questionable. This criticism applies to virtually any long-only strategy common to many of the aforementioned alternative investment categories. To be clear, “long-only” reflects a buy and hold mentality, which implicitly assumes that the associated price of that asset class can be expected to rise. In too many of those cases, however, that assumption is tenuous at best.
Despite the frequency with which the phrase “past performance is not indicative of future performance” is bandied about, promotors of alternative investment classes often point to price history as a primary basis for their optimism. To be generous, they might seem to have a 50–50 shot at being right; but to my mind, that ain’t enough. It seems to me that some higher threshold should be demanded to justify exposing capital to risk.
Any active trader quickly comes to realize that even with the most diligent research intended to winnow out prospective candidates for investment, some picks will inevitably disappoint. The trick in investing boils down to accepting this truism and using a discipline to contain the losses on those choices that don’t pan out. Price forecasts don’t have to be correct all the time, but it’s not unreasonable to expect successful traders to be right more often than not. Still, even if you select an equal number of winners and losers, as long as gains on the winning investments outpace the losses on the losers, you can end up establishing an attractive track record.
Actively managed funds attempt to do just that. In fact, I’d venture to say that the discipline that they impose to limit their losses may be as important if not more so than any skill at correctly discerning the direction of future price moves. This caveat doesn’t apply, however, to long-only programs. Long-only strategies stick to their allocations, regardless. They are perpetual bets that prices will go up, no matter what. How dumb is that?
Sure, a long-only strategy might enhance a broader portfolio’s value for some period; but inevitably, prices will turn around and the contribution to returns will be negative. Do you expect long-only managers to tell you when to get out of their funds? Not likely. These managers earn fees when they manage your money, and they’re incentivized to keep as much under management as they can. In my estimation, promoting these funds as a diversification tactic is a smokescreen for a far less lofty intention.
