Originally published in the Brandywine Asset Management Monthly Report.
The vast majority of people do not maintain diversified investment portfolios. This is not necessarily their fault. They have been taught, through the popular press and by financial “professionals,” to gamble with their money. This is evidenced by the fact that when stocks and bonds rise in value, most people’s portfolios also rise in value. This shows, all by itself, that their portfolios are undiversified – a single “return driver” dominates their portfolios’ performances (as discussed in last month’s report here). As Mike Dever states in the chapter on gambling, investing and trading in his best seller, “If you are acutely aware of every fluctuation in the U.S. stock market, then you certainly have too much riding on the outcome. You are gambling.” Many financial advisors try to overcome this unfortunate situation by preaching to their clients to disregard such fluctuations and “invest for the long run.” But this doesn’t reduce the risk, it merely ignores it! If investing were a fantasy, this might make sense. (“Pay no attention to that man behind the curtain”). But it is very real, and risk must be dealt with head on.
There are two primary reasons people continue to be taught to gamble with their money. The first is based on an erroneous definition of risk. Often without even being aware of it, most people equate different with risky. Since ‘everyone’ preaches and holds portfolios dominated by stocks and bonds, it is considered risky to do something different. If you are an institutional investor whose performance is benchmarked to the S&P 500, there is career risk in deviating substantially from that index. Also, because individuals are often so fixated on the stock market, many financial advisors risk (there’s that word again) being fired by their clients if their portfolios underperform the major stock indexes. Rather than educate those clients on the benefits of true portfolio diversification versus gambling their money, they take the easier path of risking their clients’ portfolios rather than their own financial security. But for the vast majority of individuals, career risk is the wrong definition of risk. Their risk is defined by their probability of falling short of their required financial goals, such as funding a college account for their children or creating a nest-egg for retirement. Employing true portfolio diversification lowers that risk.
The second reason people continue to be taught to gamble is ignorance. Many financial professionals are not aware of the options available to diversify their clients’ portfolios. Virtually all the major financial publications, Internet web sites, TV broadcasts or certification programs define investing as buying stocks and bonds. There is an occasional mention of “alternatives” but the name itself suggests these are ‘optional’ investment opportunities—certainly not primary.
But there is one primary way to reduce portfolio risk, which is to employ “true” portfolio diversification. Brandywine does this by diversifying across dozens of return drivers and more than 100 global financial and commodity markets. The results are significant and can be seen in the stability of returns over time. Let’s take a look.
As Mike Dever points out in myth #9 of his book, “Risk Can be Measured Statistically,” volatility is a very poor measure of risk and in itself can be very volatile. This is a drawback of the Sharpe ratio – a common performance measure – which equates volatility with risk. But what is interesting is that by measuring, over longer time periods, the volatility of the Sharpe ratio, you can start to see the true risk underlying a portfolio. That is because portfolios dependent on just a few return drivers will eventually suffer significant losses when those return drivers fail to perform. This is exactly what is apparent in the chart below, which tracks the rolling 3-year Sharpe ratio for the S&P 500 and the tested performance(1) of Brandywine’s Symphony program from 2002 through June 2011. As can be seen in the chart, the Sharpe ratio for the S&P 500 varied considerably over the period while that for Brandywine’s Symphony program remained relatively stable.
This performance stability continued after the start of actual trading in Brandywine’s Symphony program in July 2011. Since that time the Sharpe ratio for Brandywine’s Symphony program, currently at 1.15, has hovered near its long-term average. On the other hand, despite the historic rally in the S&P 500 over the past few years, and the fact that its current Sharpe ratio (at 0.89) is well above its longer-term average, that value is still quite a bit below that of Brandywine’s Symphony program. This is not unexpected and provides further evidence of the global diversification value provided by an investment with Brandywine. The result is true portfolio diversification, which provides greater returns with less risk than the S&P 500.
(1) HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.
ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.