Is Your Portfolio Well Diversified?
The best way to reduce portfolio risk and achieve good long-term returns is to have a well-diversified portfolio. Modern Portfolio Theory proved that by increasing diversification, you could reduce the risk in your portfolio and increase your return.
Craig Israelsen, PhD, a professor at Brigham Young University and author of 7Twelve: A Diversified Investment Portfolio with a Plan, has done significant research in this area. Last October, I saw him speak on asset class diversification and its impact on portfolio return. I've read the books and have seen other presentations on asset allocation, but Israelsen offers something different.
The Benefit of a 12-Asset Portfolio
Israelsen's studies show that choosing 12 equally weighted specific asset classes will generate a portfolio that historically has performed well with low volatility. This is all well and good, but what about timing? I have seen many presentations where people show how their portfolios have done better than the typical 60-40 portfolio because they included funds such as high-dividend yielding (HDY) funds (and it just so happened that their company had a high-dividend yielding fund that they recommended), or other funds that just happened to be hot at the time. My problem with the HDY approach has been timing, construction and high costs.
- Timing: While the portfolio may have done well over the chosen time, how does that apply to today and tomorrow?
- Construction: Most high-dividend paying stocks are also high book-to-market companies, also known as value companies. Aren't most of the companies in these funds already represented in my value funds? Yes.
- Cost: The HDY funds are typically more expensive than value funds, so are they worth the extra cost?
Increased numbers of commission brokers are becoming fee-based and fee-only advisors. [Tweet This]
The Importance of Objectivity
The key point is that Israelsen's study took an objective view, showing that the benefits can be achieved with different fund families, passive and active, index, ETF or higher cost actively managed funds. I am inclined to stay away from the active or high-cost funds, as there is plenty of research that shows that active funds underperform index and passive funds as a whole over time because of their excessive fees.
Brown Wealth Management is a fee-only firm, which means we don't accept commissions and, wherever possible, we look to avoid any investment that has high commissions or fees. As a result, I am always concerned about any implied conflict of interest in a study or presentation. With commissions, it is easy to see the conflict. That is why our firm doesn't accept them. We give up significant compensation because we feel it is the right thing to do for our clients. We have been doing that since we opened in 2002. The industry is shifting toward our view as large numbers of commission brokers are becoming fee-based and fee-only advisors.
Diversification Is Not Enough
Israelsen's studies concluded that the diversification alone was not enough. Consistent and disciplined rebalancing was key. Again, this conclusion was consistent with many other studies. No conflict here.
What was more interesting was the study done on the impact of holding bonds in the portfolio in both rising interest rate environments and declining interest rate environments. The study showed that the 12-asset class portfolio performed well even in the rising rate environment of 1950–1959. This is significant, given that we believe that interest rates will increase in the future. A big concern of many of our clients has been how best to invest in fixed income given that rates are currently very low. Israelsen's study showed that as part of the 12-asset class portfolio, the fixed income component will not change the outcome much. That is good, since we need the fixed income to lower the overall volatility of the portfolio.
The bottom line: We will be seriously considering increasing our clients' portfolio diversification in line with Israelsen's research.