“Do not be fooled into believing that because a man is rich he is necessarily smart. There is ample proof to the contrary.” - Julius Rosenwald

So how is all that “diversification” that various financial product marketers and asset allocation academics have been pitching for years working out for you?

Hedge funds were supposed to be non-correlated and used to “reduce portfolio risk,” but over the last year they are down 17-24%. Equity REITs and REIT mortgages were supposed to be a diversifier, but they are down 37% plus. Foreign stocks and emerging markets were supposed to diversify away some of the equity market risk exposure, but they are down 46-56% respectively. TIPs and high yield bonds were supposed to help “diversify” fixed income allocations, yet relative to plain garden variety intermediate government bonds they have underperformed by 18-27% respectively. Commodities were another “asset class” tossed into the theoretical diversification bucket, but they are down 26%.

Many in the industry raised shrill and unpleasant complaints when I criticized the bromides product marketers used to push these expensive and so-called diversified alternatives. To them I simply say, “I told you so.”

All of these asset classes (a term used very loosely by the expensive product purveyors) were supposedly going to protect you by lowering portfolio risk, which would justify the high expenses. Also, the theoretically more diversified allocation strategy was not only going to “lower” portfolio volatility but was supposed to enhance your compound investment return to boot.

The price of bogus diversification

Pretty pie charts with numerous multi-color slices have enchanted both investors and advisors alike. But simple allocation models, based on the main drivers of the variance in portfolio returns (stocks, bonds and cash per Brinson, Hood and Beebower¹) appeared to be too easy to create, and less diversified. Also, such simple portfolios were very inexpensive to assemble from ETFs (weighted average expense ratio of about 0.16%) which meant that massive product fees were impossible to justify without the added mystery of other “sophisticated” assets.

The “Broadly” diversified balanced portfolio with more risk than equities

A simple and low cost balanced ETF portfolio allocation, based on generic indices* would be down about 21.5% for the year ending 11/30/2008 (actual results can be a little better, depending on the ETFs used). The pie chart for the allocation is unimpressive and visually even looks less diversified than a “more sophisticated” allocation strategy (See Figure 1).

But look at how beautifully colorful the more sophisticated and “more” diversified balanced portfolio offered by the “sophisticated” product purveyors and asset allocation academics is…clearly it would have less risk! Just look at all of those pie slices! (See Figure 2)

Figure 2- “More” diversified “sophisticated” balanced portfolio allocation,
DOWN 40% for the year ending 11/30/2008

Wait a minute! With all of those extra slices, with all of that “extra” diversification, HOW can this sophisticated balanced portfolio be down more than total domestic equities??? Wasn’t this balanced allocation supposed to reduce my risk? And, how can a basic 60/40 stock/bond portfolio outperform this more sophisticated and theoretically more diversified portfolio by 19% over the last year? 

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