C'mon Ken

Regular readers of TWR know that there is only one thing I’m more picky about than the type of bourbon I drink and that is the information I allow into my investment process.

Life is to short to drink cheap bourbon or to allow every blog post or news article to influence your investment process.

There is more information available today than at any other time, which means there is more bad information out there today than at any other time. That's why it's critical that you carefully curate your sources of information -- keep it simple but make it significant. Less is definitely more.

That said, from time to time, I like to pull my head out of the sand and look at what the mainstream media is saying and what the general “consensus” conversation is about the financial markets.

Last week I came across a Forbes article by Ken Fisher entitled, “5 Market Trends You Can Bank On.” For background, Ken Fisher’s firm, Fisher Investments, manages over $60B for institutions and high net worth individuals. Fisher himself is listed as #225 on the Forbes list of billionaires. Anyone who manages a significant amount of money and has amassed a fortune himself must know what he’s doing, right?

The crux of the article rests on three statements.

1. Nothing but excessive optimism and an unexpected economic problem can derail the current bull market in US equities.

2. It doesn’t matter when the Fed raises rates because it's already priced into the market and rate hikes don’t say anything about future stock returns.

3. Diversification is the path to the investing promised land.

While I could write a short novel debunking the first two statements, I decided it's better to simply dig into his comments on diversification.

Diversification is probably the most overused, misunderstood word in the investing lexicon. A quick Google search yields this top result for a definition from Investopedia, “A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. The benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.”

This last statement is the critical one. The holdings in your portfolio need to be un-correlated in order to provide true diversification benefits. Simply having 600 holdings in an account doesn’t guarantee lower risk. The crucial point of diversification that most people, professional or otherwise, miss is that the holdings in an account need to have different drivers.

For instance, if for the last 6 months, you’ve been long US stocks, short US bonds, short the Euro and Yen, then you have essentially 1 position in your account. All 4 of those trades are working off the same driver, namely the US Divergence Trade.

So, if US growth slows more than expected or the Fed decides not to raise rates, all of your positions, with the exception of US equities, will begin to move against you. Is that diversification? You are better off, from a risk perspective, to choose the one position that best captures the US Divergence Trade theme rather than spreading capital out over 4 different positions because it makes you feel like you’re taking less risk.

Now, back to our boy Ken. What does he have to say about diversification? Here’s hisresponse to the question, With foreign stocks leading U.S. stocks now, should we dump our U.S. holdings? ”Think global always, and unless you think you’re a lot smarter than everyone else, in which case you won’t take my advice anyway, never let yourself vary too darned much from the world’s big weights–currently 52% U.S., 23% Europe and 25% everything else. The world is your friend–more diversification.”

First off, what exactly is “everything else?” How am I supposed to put 25% of my portfolio in “everything else?” Second, it took all of about 2.5 minutes to debunk his advice. Anyone who has been trading markets for any length of time knows that European stocks are highly correlated to US stocks. You can certainly cherry pick time periods, 2015 being one of them, where the price action of European stocks and US stocks have diverged. But those divergences don’t last long and always come back in line.

So, my hypothesis is that a portfolio that is 75% US stocks and 25% everything else will perform the same or slightly better than one that is 52% US, 23% Europe and 25% everything else. If we assume that “everything else” is emerging markets, then here are the stats of the two portfolios.

You can see that adding a European slice to the portfolio doesn’t decrease the risk one bit. The 75% US equity portfolio had a more shallow drawdown and lower annual standard deviation than Fisher’s World portfolio. The 75% US portfolio also fared better during the Russian default and the Financial Crisis than the “more diversified” Fisher portfolio. Oh, and the non-diversified portfolio also had a better rate of return over all time periods tested. Better performance, lower risk. Wait, I thought that’s what diversification was supposed to provide?

The follow-up question was whether Fisher’s thoughts about diversification applied to individual stock sectors. “Absoposilutely! Sectors: 22% financials, 14% tech, 13% consumer discretionary, 12% health care, 10% staples, 10% industrials, 8% energy and 11% everything else.”

Ignoring the fact that he invented a word, here he goes again wanting to invest a portion of the portfolio in “everything else.” In this instance, I’m going to assume he’s referring to the 2 sectors that were missing, which are utilities and basis materials.

I’m going to hypothesize that a portfolio that is 100% US equities will have similar performance to Fisher’s Sector portfolio with less risk. You can see from the chart that this is exactly what we find. The performance for the two portfolios is nearly identical for all time periods tested.

As for risk, the 100% US equity portfolio had a more shallow drawdown, less annual standard deviation, and outperformed Fisher’s Sector portfolio in all 3 crisis events I examined, including the September 11th.

I wouldn’t “bank on” Ken Fisher’s perspective on diversification providing you with better returns and lower risk. Remember, adding more positions to your portfolio doesn’t necessarily change it’s risk profile. You must add positions that have different catalysts.

Keep in mind, that there are generally only 2-3 catalysts for asset prices in the world at one time. So, if your portfolio has more than 10 or 15 positions, you’re channeling your inner Ken Fisher and you really need to think about whether your truly diversified or not. I’m going to channel my inner Chris Carter, “C’mon Ken!”