There is a saying in financial markets – There is no free lunch. It means that the returns you make, are commensurate with the risks taken. For example – Higher return from smaller companies goes hand in hand with a higher risk of loss in this space. This was seen in spades during the 2018-2019 period when the index dropped by 40%+ and several companies by much more
A key point which is missed by most investors is that risk is clustered – It does not happen evenly over time. You will get a long period of high returns and then lose a lot of it in a short window. Most investors ignore this point towards the end of a long bull run and get hurt in the inevitable bust
The standard approach to managing this risk is via asset allocation and diversification. I wrote about it in detail under the section ‘Asset allocation and diversification’ in my annual letter to subscribers
Diversification been called the only free lunch in the market. It means that if you diversify across asset classes and rebalance regularly, you will make a higher ‘risk adjusted’ returns. What this implies is that you will not make the highest returns at every point of time but will make good returns over a long period of time.
Point returns v/s long term returns
This brings me to the problem of perverse incentives in the financial services industry. Any time an asset class is in a bull run, you will find a host of advisors and fund managers touting their fund as if it is permanent and will last forever.
An illustrative list
2003-2008: Real estate, Commodities, Infra
2014-2017: Small cap
2018-2019: Large cap, quality
2020: Gold
How do you manage this problem? It’s quite simple: Just diversify across asset classes. Define a target allocation and rebalance at a pre-determined frequency. I can assure you that you will do well in the long run and will also have the bragging right of being invested in the ‘hot’ asset class of the moment (just don’t talk about the rest of your portfolio)
Going beyond Asset classes
There is another approach to diversification which complements the above approach. It’s called factors-based diversification. Let me explain
You can find details on factors here. Quite simply, Individual factors are quantifiable variables which can be used to explain the returns of a stock/portfolio. Following are the key factors with a simplified explanation for each
Value: Cheapness or valuation. Cheaper stocks deliver higher returns
Momentum: Persistence of returns. Any stock/asset which has done well recently will continue to do well.
Volatility: Less volatile assets give higher risk adjusted returns
Size: Smaller companies give higher returns than larger companies (adjusted for risk)
Duration/Yield: Longer duration assets give higher returns than lower duration ones. For example, 10-year bonds give a higher return than 1-year bonds.
These factors have been researched and empirically proven to be robust across asset classes and time periods. The reason they work is that individual factors do not work all the time. This is the same point I made for all the asset classes: No asset gives high returns all the time, even if they give higher returns at various points of time.
We can expand our diversification approach to include factors. There are times when value stocks will outperform momentum stocks. At other times, quality stocks will outperform other factors.
No one can predict which asset class or factor will gain market fancy in the future. As I shared, the best way to manage the timing issue, is to diversify on both the parameters: asset class and factor type
How to diversify across factors
There are two obvious ways to diversify across factors. The simplest one is to split your funds 50:50 between Value and momentum funds/indices. As value and momentum factors are not correlated (when one works, the other doesn’t), you will do well irrespective of which factor is in favor
The other more complicated approach is to build a portfolio, which is a combination of the Value, Momentum, and quality stocks. This means that some of your positions will be deep value, some will be low volatility & high-quality positions and the rest would be momentum stocks. To keep it simple, you can just divide the allocation evenly among all the factors.
The downside of the second approach is that it requires far more effort and works only if you are an active investor who wants to get every possible edge in the market
Isn’t diversification for the clueless
A common push I get is that diversification is for the clueless (as Buffett says so). My glib answer is that most investors are not Warren Buffett. I have now been investing for 20+ years and no matter how hard I work, I will never be a super investor like one of the greats.
It is nice to quote these statements from the super investors, but the more important point is to evaluate your own performance and come to your own conclusions. I know for a fact (supported by evidence), that I have been far better served by being adequately diversified
In most cases, one would be far better served in being adequately diversified across asset classes and factors. It may not make you rich but will ensure that you have an adequate nest egg at the end of it.
