The Twisted Lies of Diversification

Whether you run a Fortune 500 company or your own portfolio of investments, there's one thing we all have in common: a shared belief engrained since childhood that we shouldn't put all of our eggs in one basket.

But what if the seemingly sage advice of investment diversification has been misguided? Or worse, a twisted lie peddled by the best funded marketing minds from Wall Street? After all, Wall Street and the mutual fund community have made copious amounts of money on this single idea of spreading risk by buying more of their products. What if their approach to diversification was based on badly skewed math and data?

For initial proof consider the crash of 2008 and 2009. You may have been told that you were diversified before the Great Recession, but that did little good because you still lost a significant amount of money.

That's because the vast majority of money managers and financial professionals buy into an approach to diversification that fails accurately measuring levels of risk. Their failure to manage risk prudently revolves around the incomplete understanding of correlation and inadequate measurement of risk:

Lie #1 - Correlation Risk

Correlation deals with the relationship of one asset class to another. A properly diversified portfolio should hold it's own during good, and more importantly, bad markets. More simply put, when stocks lose money you want to include other investments that move in an opposite direction (they go up). The problem with correlation risk is that during times of crisis most asset classes become interwoven and react similarly. In 2008, the S&P 500 was down 37 percent. Hedge funds, seemingly meant to hedge against risk and be uncorrelated to stocks, lost 19 percent, while privately held commercial real estate (also considered uncorrelated to stocks) lost close to 7 percent. While these are just a few examples of correlation the lesson for you to take away is that during times of crisis common approaches to diversification do very little to shield you from losing serious money.

Lie #2 - The Forgotten Siblings to Standard Deviation

The most common form of measuring risk in an investment portfolio is to calculate the standard deviation. Standard deviation tells you, in essence, how volatile the returns may be.

Advisors and money managers treat standard deviation as the gospel for measuring risk, but this has been irresponsible because it has left your money wide open to crashes like 1987, 2000, and 2008.

For example, most advisers tell you to invest in a balanced fund or portfolio. The standard deviation for a 60/40 portfolio (60% stocks, 40% bonds) during 2000-2012 was 10.95 percent, which has subjected your life savings to restless risk. Frankly, that's bad math and bad management because they've forgotten the critically important siblings of standard deviation: skewness and kurtosis.

Skewness tells you if the returns of a portfolio will be skewed to be more positive (higher return/growth) or negative (lower return/loss), obviously you want a portfolio that is positively skewed. The 60/40 portfolio over the last 12 years has a negative skewness of 91 percent indicating a lot of downside risk.

Kurtosis is often referred to as the "volatility of volatility" and tells you the distribution of returns i.e. does a portfolio tend to perform close to the mean (the peak of a bell curve) or are the returns all over the place (a short & squatty bell curve with "fatter tails"). A high level of kurtosis demonstrates a less "predictable" or more volatile portfolio. The common 60/40 portfolio over the last 12 years has had a kurtosis of 87 percent indicating that returns have been all over the place and less predictable (think shotgun blast versus a sniper rifle).

We All Want The Same Thing

Investors like you want the same thing; the highest return with the least amount of risk. Unfortunately, if you keep investing the same old way you may experience another decade of disappointment because your portfolio is still infested with flawed math and abundant risk. The perfect portfolio would have the least amount of standard deviation, a positive skew, a lower level of kurtosis and a high-level of return. After crunching monster amounts of data here's an example of a better allocation versus the antiquated 60/40 portfolio approach:

2000-2012 Flawed Diversification Truly Diversified*
Allocation 60% Stocks / 40% Bonds 40% Bonds, 15% Stocks, 35% Trend Following Managed Futures, 5% Hedge Funds, 5% Private Real Estate
Standard Deviation 10.95% 2.61%
Skewness -91.7% 42.5%
Kurtosis -91.7% -60.27%
Total Return 164% 180%

Ask your adviser to perform a stress test on your portfolio to uncover kurtosis and skewness risk; if he looks at you like you have three heads it's time to hire a new adviser that can deliver the goods.

Robert Russell is the author of Retirement Held Hostage, CEO & CIO of the Ohio-based Russell & Company, a private wealth management firm specializing in helping affluent individuals ages 45 and up create and preserve their wealth. He co-hosts a radio show, authors The Rob Report blog, and is a frequent contributor to The Wall Street Journal, SmartMoney, & FOX Business.

*Note: Index performance data obtained from S&P 500TR (stocks), Barclays U.S. Aggregate Bond Index (bonds), Barclay Systematic Trader Index (trend following managed futures), HFRI Fund Weighted Composite Index (hedge funds), NCREIF index (private real estate). Returns do not include fees because they are indexes and cannot be directly invested in.

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