Diversification

[Zaphod]

There has been a bit of discussion about diversification here and how portfolios are tilted. There was an excellent article today on the subject, short and to the point. Its likely just an unnecessary risk for not enough reward to be 100% equities all the time. Which used to be my view when I first saw the long term returns, before taking into consideration risk adjusted, time frames, sequence of returns, etc...one can only learn so much so fast.

http://awealthofcommonsense.com/2016/02/how-to-manage-risk-when-the-market-owes-you-nothing/

Read an old paper last night (1996) that discussed this same idea. Usually whats touted in finance is to get the best risk adjusted return and lever up, similar to risk parity now. A 60/40 portfolio levered to match risk (would have been to 1.55 during the study time) even outperformed 100% stocks including the crazy 80s run. Something to ponder.

[jfoxcpacfp]

Zaphod wrote:

There has been a bit of discussion about diversification here and how portfolios are tilted. There was an excellent article today on the subject, short and to the point. Its likely just an unnecessary risk for not enough reward to be 100% equities all the time. Which used to be my view when I first saw the long term returns, before taking into consideration risk adjusted, time frames, sequence of returns, etc…one can only learn so much so fast.

http://awealthofcommonsense.com/2016/02/how-to-manage-risk-when-the-market-owes-you-nothing/

Read an old paper last night (1996) that discussed this same idea. Usually whats touted in finance is to get the best risk adjusted return and lever up, similar to risk parity now. A 60/40 portfolio levered to match risk (would have been to 1.55 during the study time) even outperformed 100% stocks including the crazy 80s run. Something to ponder.

Click to expand...

The articles are spot on but I saw nothing that address your commentary.

[TheGipper]

I am a REIT, value, and small cap tilter, BUT i think 99% of investers (myself likely included) would be better off without the tilt.  Several things have to become aligned to be a successful tilter.

1)  One has to REALLY believe in the academic research supporting the tilt.  This is no easy task given the relatively small time horizon these theories are tested and of the modern market overall.

2)  One has to make a long term commitment to the tilt.  For example, it is quite possible the value premium may not re-appear for another 10+ years, maybe not even in one's investing lifetime.  If you are are value tilter, are you prepared to eat subpar returns and keep rebalancing and redoubling down on value stocks.  If not, don't bother tilting.

3)  One has to avoid the tempatation of adopting new tilting strategies that may cancel out the benefit of pre-existing ones.

Due to all this I have a stronger tilt towards REITs than small/value or emerging markets because I believe in them more, and feel l have more of a chance to keep rebalancing into them over a decade of underperformance should it happen.

What would you do if your value stocks or emerging market stocks severely underperform for the next ten years?  Do you have the confidence to keep doubling down?  If so, you may be the rare successful tilter.

[Zaphod]

I am not necessarily a tilter. I do believe there are certain setups that more or less give a head or tailwind to your strategy and those are important to keep an eye on. There has also been a recent paper about factors and how after being published, get jumped on almost eliminating any alpha they once had fairly quickly. This has certainly happened with value since its the easiest for a hedge fund to do with their army of analysts and quants. I realized when looking at past performance of a pure value method that it was not for me, there was a 14 year stretch of horrid underperformance in the 80sish I believe, thats longer than I want to have to work and I know I do not have a superhuman constitution and would definitely bail for the worst in that scenario (it eventually worked out, but likely no human had that portfolio over that time).

For things like small cap or even value, I think the only time I think it makes good sense is after a big draw down, like now for small caps. Doesnt mean they cant fall further but much of the "premium" is due to that volatility making it cheap at some point in time. For things like that I see myself as counter cyclical. The same with emerging markets, they have been summarily crushed, and face multiple headwinds but given they are down so fiercely and the USD strength making matters worse, I have been dipping the toes in here this year. Also have some REIT/VNQ.

For longer term tailwinds I have tilted towards tech and health as broader themes, and have also waded into some low volatility etf due to more consistent performance and literature showing better risk adjusted returns. I have VTI/QQQ in equal weights as my main index and about equal weight to VHT as the long term trends for healthcare are very good given demographics, legislation, and personal choice (show me a country where people choose not to spend on their health, they dont have to like it, but they will do it). At some point it becomes a choice of a developed nation and though it may take time Im sure we will all come to the conclusion health and quality of life are worth paying for. It also helps everythings down and I've moved into things 15-20% off the recent highs.

I think the biggest problem with tilting is the overlap between funds. I see LC V/G SC V/G MC V/G SPY and Im pretty sure there is a lot of redundancy in there that is likely simpler to cover with one or two funds. A total market, small cap, bond, and your fav flavor twist EM, health, etc...The most important part of the article above was your not actually getting much for exposing yourself to more risk. Said differently, if you were to lever up a more boring portfolio like a 60/40 to where they had equal risk (standard deviation) you would have better returns. Risk adjusting your returns are important, no need to be wild.