INCLINE VILLAGE, Nev. - At the end of the year many investors review their portfolios and evaluate their investment adviser(s). For many advisers, that isn't good news. According to Fidelity Investments, only 57 percent of investors thought their adviser performed well recently. Worse still, 43 percent thought their adviser did not earn his fee (they must not have interviewed my clients!).
What's going wrong? I suspect a big issue is that too many advisers rely on Modern Portfolio Theory (MPT). MPT, first proposed in the 1950s, says that you can minimize risk for a given level of expected return by holding a broad mix of assets (i.e., a "diversified portfolio"). The theory behind MPT is that your overall portfolio risk is lower because some securities will zig while others zag. The securities are periodically rebalanced, where you buy more of the losers and sell some of the winners.
With today's new breed of ETFs, it is easier to invest in all different markets - individual commodities, currencies, futures products, etc. Unfortunately, most of these exotic ETFs are performing poorly.
A bigger problem, however, is that the approach doesn't work in bear markets. I cringe when I hear an adviser say, "Don't worry, your portfolio is diversified." Those in favor of diversification will point to low correlation statistics in different types of securities. In calculating the correlation, long time periods are almost always used.
The problem is that the low correlation occurs during bull markets, which is when you don't need to be diversified. Then a bear market arrives and securities start to move in lockstep. Just when diversification is needed, securities become highly correlated.
One simply has to look back to 2008 to see how this works. A portfolio may have been diversified in the years leading up to that bear market, but when the financial crisis arrived, then nearly all securities moved down in lockstep. Instead of calling it diversification, I prefer to call it "di-worsification."
A better approach is to overweight the attractive areas of the market and avoid the bad ones. That's why even my largest client accounts hold fewer than 20 securities. That focus, not diversification, is how an adviser earns his fee.
- David Vomund is an Incline Village-based fee-only money manager. Information is found at www.ETFportfolios.net or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.