We’ve all heard the term “don’t put all your eggs in one basket”. Of course, this concept can be easily applied to investing. Many sophisticated investors understand that investing in only one stock, or only one asset class, or only one anything is risky. However, the question of whether or not you should invest in just one money manager is rarely directly addressed.
A key objective of diversified investing is to build a portfolio that is spread across multiple asset classes in an effort to lower the overall volatility of the portfolio.
If you invest your entire portfolio in one single stock it’s clear that your entire portfolio will be tied to the fortunes, and therefore risk of that one company. Adding additional investments to the portfolio can lower the overall volatility and risk of the portfolio, especially if you are adding additional holdings with low correlations to one another.
In other words, if your portfolio zigs, you want to add something that zags to get the most effective diversification benefit.
To take this further, if your portfolio is made up entirely of one large cap telecom stock, adding a second and third large cap telecom stock may give you little in the way diversification benefit if each of these companies have similar factors that drive their returns. Ideally, a portfolio will be well diversified among different sectors. That way, if one sector is performing poorly, this poor performance may be offset by other sectors with stronger performance. Likewise, geographical diversification is important to help mitigate the impact of a poorly performing market.
A dividend manager such as Thomas Partners will likely invest almost exclusively in domestic, large cap dividend paying stocks. While it may make sense to use the Thomas Partners Dividend Growth strategy to fill the need for this piece of your portfolio, it probably doesn’t make sense to use this one strategy for your entire portfolio. By putting all of your assets with one strategy that invests in one corner of the market, you will likely have little or even no exposure to mid-cap or small-cap holdings and little to no exposure to non-US holdings and no exposure to non-dividend growth companies.
Moreover, a single strategy may have overweights or underweights to certain sectors. For example, dividend strategies are typically overweight to consumer defensive and telecommunications and underweight to more aggressive sectors such as technology. If you use a single strategy for your entire portfolio, the entire portfolio will have these same overweights and underweights.
Core Satellite Approach
Using a strategy that focuses exclusively on mega-cap stocks such as the Fisher Investments Global Total Return strategy can leave your portfolio short on small cap stocks and emerging markets stocks, for example. One potential solution to this problem is to use a core satellite approach to constructing your portfolio. You begin with a core holding which is typically a large cap manager and then add diversifying pieces (satellites) such as small cap and emerging markets strategies to round out your full portfolio. Again, to achieve the most diversification benefit the satellite pieces should be unique investments that are not highly correlated to the other strategies in the portfolio. Adding a large cap technology strategy as a satellite to a large cap core strategy would offer little in the way of diversification benefit since you’d simply be adding to your existing exposure to large cap technology.
Another key aspect of diversification is to diversify among different investment processes and methodologies among active managers.
For example, if you have your entire portfolio with a single tactical strategy like Churchill Investment Management Tactical Core, the returns of your entire portfolio would be driven by the decisions made by one person (or one group of people) using their specified investment process. Perhaps a tactical strategy could be used as a satellite piece to complement core strategy that has a different methodology. Again, ideally to achieve the maximum diversification benefit, the different pieces of a portfolio should have a low correlation to one another.
When evaluating an active strategy investors should seek to understand what drives the performance of that particular strategy and in what type of environments that strategy has historically performed well and in what type of environments that strategy has performed poorly in. If a strategy in your portfolio tends to perform poorly in a rising interest rate environment, for example, it may make sense to add a strategy that tends to perform well in a rising interest rate environment.
The WrapManager Approach
At WrapManager, we seek to construct client portfolios that are diversified among asset class, sector, geographical location and investment methodology among active managers, as appropriate to each client. A portfolio with too much of a narrow focus can be subject to poor returns when this very specific niche of the market goes through periods of market stress and there are no diversifying pieces to offset the volatility.
An investor who is choosing among different investment strategies that they like should be asking themselves “how much of my portfolio should I allocate to each of these strategies?” rather than “which single strategy should I choose for my entire portfolio?”
But, there’s no reason for an investor to evaluate managers and build an investment portfolio alone. WrapManager Wealth Managers are available to help you select money managers and strategies that are appropriate to your investment goals. To get started, request your free money manager choices here now.
Diversification does not guarantee profit or protect against loss in declining markets nor does it guarantee a certain level of investment returns. Past performance is not indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy will be profitable or equal the corresponding indicated performance level(s). This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you.