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The Diversification Fallacy

The Diversification Fallacy

Even after educating clients on “diversification” and managing client emotions and behaviors, advisors often find themselves in an uncomfortable position when portfolios have unexpected losses. The traditional notion that a diversified portfolio is less volatile rests on the belief that stock and bond markets tend to move in opposite directions, which stabilizes the portfolio. 

This is a basic principle behind the classic 60/40 portfolio. But even normal market volatility is probably higher than you think, and most asset classes are fully exposed to changes in market volatility. On top of this, volatility is extremely hard to forecast. When volatility spikes, most asset classes tend to decline in unison, as correlations rise. 

The diversification investors thought they had quickly disappeared. Frankly, it is hard to be an investor, and arguably harder to advise investors. On top of rapidly changing market dynamics, the operational demands of an advisory practice often leave little time for managing the always evolving risks to redefine client portfolios. 

At day’s end, most advisors probably spend 80% of their time managing their practice and trying to stay current with regulations and technology, and increasingly complex investment products. In the past, before the Great Financial Crisis of 2007 and 2008, spending 20% focused on managing client accounts was reasonable. A diversified stock and bond portfolio was usually enough to protect clients from the worst of the financial markets and the global economy. 

In the shadow of the worst financial crisis since the Great Crash of 1929, risk has become more nuanced as the markets have become increasingly interconnected. Historical patterns that have long animated the securities industry’s reliance on diversification and many other principles of the Modern Portfolio Theory, or MPT, are no longer the near-constant curatives that they once were. Advisors and investors must evolve investment approaches to ensure that their investment accounts are properly situated and that they are able to withstand the rigors of a modern, electronic market.   As clients aged or grew more conservative, balanced accounts were easily adjusted by shifting money from stocks to bonds. 

But we live in a different age where bonds can be as risky, and even riskier than stocks. The markets of the past are not the markets of today. This is due to technology, the increased interconnectedness of economies and trade, and the birth of new asset classes such as volatility and the growing use of derivatives to manage fixed income and equity exposures.

Moreover, as the Federal Reserve grapples with a multi-year program to raise interest rates from historically low levels, bonds may ultimately bully stocks. At the same time, higher rates will squeeze investors, and especially anyone who has borrowed money in the expectation that rates would remain lower for longer. 

This introduces a swatch of uncertainty into the markets, and the economy, that has not been experienced in many years. Anyone who is near retirement age, or who has retired, faces significant challenges that are likely not fully appreciated by advisors, investors, and even policymakers and central bankers. The challenge thus becomes understanding different kinds of risks portfolios are exposed to and managing those risks and investor emotions to protect the money that has been saved and invested over one’s working life without sacrificing potential future gains.

Our PRISM™ risk analysis software uses a blend of risk tolerance questionnaires, historical market events, and current market signals to provide advisors with all the data they need to know their customers and plan accordingly. Contact us to find out how StratiFi can help your practice and clients monitor risk across all investment holdings regardless of market conditions.

Akhil Lodha Author
Co-founder & CEO StratiFi Technologies

Building the industry standard for understanding portfolio risk through cutting- edge technology at Stratifi.

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