August 2014Finance

Diversification Today — How Much Is Too Much?

diversification today

What’s one of the most common mistakes made by investors? According to Wharton finance professor Jeffrey Jaffe, it’s under-diversification. A portfolio invested too heavily in any one asset or asset class exposes investors to too much risk. “It is well established in terms of research that one of the biggest reasons investors aren’t diversified enough is that they buy too much of what they know and feel comfortable with.” Typically, that means they are overinvested in assets from their own country. But it could also mean, more dangerously, too much of one stock or type of stock.

Why do so many individual investors, and even fund managers, ignore the adage, “Don’t put all your eggs in one basket”? Jaffe says home bias — the irrational preference for what’s local or well known — is often to blame. It’s not hard to find evidence of just how risky that preference can be: just remember the employees of companies like Enron, Lehman Brothers, and Kodak. While stock purchase programs can be enticing, they can also leave investors with too much company stock— never a good idea, no matter how loyal you are to your employer. And even if investors manage to diversify in terms of individual stocks, they often look only to U.S. companies and the funds that invest in them to fill their portfolio.

 “We used to think this phenomenon was primarily an American one, since initial studies used mostly U.S. data. We’re a big country with a big economy, most Americans speak English only — it is easy to see the basis for the conclusion,” says Jaffe.  But, he notes, recent research shows otherwise. “Home bias is an international phenomenon. Investors in every country make the same mistake, and in many cases it’s worse for them. The U.S. is a large part of the world market and has done well recently, but investing 90% in U.S. stocks is still not advisable. The effect is much stronger on investors in other countries because their market cap is so small. For example, a Korean investor who invests 90 percent in Korean stocks is in trouble.”

But there is some good news, especially for advisors working to help their clients rebalance their portfolios. Jaffe says home bias is “the quickest thing to be corrected. Everyone in finance has to think internationally today, and it has become easier to invest in equity outside your home country. In the decades I have been teaching in Investment Strategies and Portfolio Management, I have noticed this shift. Our participants are more diverse geographically, and they bring a greater diversity of viewpoints.”  Jaffe, who serves as academic director of the program, notes that discussions about international diversification and home bias are richer in that environment.

But if some diversification is good, can more be better? The Endowment Model departs from the traditional 60 percent stock/40 percent bond model and allocates a significant portion of assets to alternative or non-traditional asset classes. Those investments include, in part, hedge funds, real estate, timber, oil and gas, and private equity. Today, many large endowments and pension funds follow this model, including famous investors like David Swensen of Yale, and have up to 80 percent of their assets in these types of alternatives.

Is it a good idea? It depends whom you ask. The model has recently been criticized for not capturing index gains during the bull market, even though its overall track record is solid. Christopher Geczy, Wharton adjunct finance professor and academic director of the Wharton Wealth Management Initiative and the Jacobs Levy Equity Management Center for Quantitative Financial Research, says the critics are missing the point.  “Much of the Endowment Model talk lately is wrong-headed. Many of its critics are not taking into account the needs of endowments and the role of their investments. These institutions rely on investment income to fund operations, scholarships, research, and construction. If they invested solely in equities, they would be experiencing the upside today, but they would also be at risk for the downside. Volatility on the downside can be disabling for a university and in fact for many investors, and it is understandable why they want to guard against it.”

Geczy notes that the model also makes sense for schools because they have a longer horizon and are able to invest in classes of investments that many can’t or don’t access. “They’re not trying to beat the market in every three- or five-year time period — that is not a precept of the model; they are taking a long-term view. And doors are open to them that are not open to others. Historically, they could invest in  alternative types of assets that serve their diversification and return objectives, ultimately providing them exposure to return-generating risks and strategies generally not available via less sophisticated approaches, and in some cases are paying  lower fees, although that’s not a guarantee either,” he says.  “It is important to note that the model has been democratized in the last decade or so, so that now other institutions and in fact some individual investors might be able to follow endowment-style approaches,” he adds.

The recent criticism, according to Geczy, has a lot to do with timing. “They’re getting bad press now because the equity markets have been doing well. It’s a common phenomenon. When equity markets are raging, you often hear people talk about ‘diworseification.’ But we can go through another downturn — or even just downside volatility — and diversification and the Endowment Model will look good again.”

If you’re confused about this latest debate about diversification and the Endowment Model, Jaffe has some advice. “We at Wharton are sorting this out for you. The goal of Investment Strategies and Portfolio Management is to provide in one week a solid foundation in today’s asset choices and investment models — including the 60/40 model and the Endowment Model. We compare them, and look at the tradeoffs for each one, and give participants the tools they need to apply what they’ve learned.”