In a recent Blog post I discussed the supermarket approach to markets. To remind you, I suggested most nutritionists tell us we need a balanced diet to be healthy and supermarkets provide submarkets of the basic food groups – protein, carbohydrates and fats. The stock market does the same thing, only they are called asset classes – large cap and small cap, value and growth. How you combine these sub markets is the basis for efficient and inefficient diversification.
These two kinds of diversification – efficient and inefficient diversification are the foundation for developing a healthy portfolio. You might be asking yourself, “What is inefficient diversification?” Simply put, your portfolio is either diversified or it is not. However, that is not really correct. With a little research, it is easy to see there are many different kinds of mutual funds all fishing in the same markets, looking for good investment opportunities, so they can bring value to their investors. Active management drives these funds to select stocks based on their short term outlook and in many cases results in high turnover. High turnover then means hidden higher trading costs. Most importantly, since the analysts are all looking for the best stocks to hold in their portfolio, it is easy to end up with eight or ten funds with similar holdings.
Efficient diversification focuses on owning distinct asset classes that do not overlap in stocks. Why? Statistical analysis shows submarkets do not necessarily perform with the same characteristics. These asset classifications (small, large, value, growth) have different characteristics and perform differently over time. This is measured by what is called correlation coefficients. If the CEs are negative, then the asset classes will act as counter balances to each other during economic cycles. If they are all positive, there is no real diversification. They are all moving the same direction at the same time, which will cause the diversification to be less efficient.
When you are helping clients manage money, it is important to have a philosophy and a way to execute your philosophy. There is more to managing money than buying a diversified portfolio of mutual funds. You must make sure the funds are equally and adequately diversified and don’t cause unexplained risk for your client. Knowing the correlation coefficients of the asset classes is integral to building an efficiently diversified portfolio.
