Wharton@Work

January 2018 | Finance

Portfolio Management: Are You as Diversified as You Think?

Most investors think of diversification across asset classes: a portfolio of all stocks, all bonds, or all real estate would expose you to tremendous risk. But, says Geoff Gerber, president and chief investment officer of Twin Capital Management, Inc., asset classes are just one level of diversification, and the larger the portfolio, the greater the need for even more diversity.

Gerber, who teaches in Wharton’s Investment Strategies and Portfolio Management, says once there is an investment policy statement in place that specifies the objective (for example, earn a return of 7.5% with the least risk possible), you can start building the portfolio to best meet that objective. “First you have to consider asset classes, and the policy statement might even spell out which classes can and can’t be in the portfolio.” He stresses that in addition to asset classes, investors must consider diversification within those classes.

“Many people stop at the asset class level,” says Gerber. “There has been tremendous growth in the number and types of investment opportunities, and investors can be challenged just keeping up with them. That’s one way our program has changed over time. When I started teaching in it 30 years ago, portfolios were mostly stocks and bonds. Now as new opportunities arise, such as private equity and derivatives, we bring in experts who provide a wealth of information and insights into when and how to consider them.”

Gerber’s expertise is in helping participants put it all together. Considering the equity portion of a portfolio alone, he says to think of yourself as a manager of a baseball team. “You need someone in right field even if most batters don’t hit there. The same thing is true in equity markets. Small cap stocks in the long term outperform large. But in the past few years that has not been true. You need to cover every position, so if the ball is hit there you have someone who can field it. Get exposure everywhere. Think broadly — both across asset classes and within them.”

That means in addition to segregating by large-, mid-, and small-cap, consider investing in diverse sectors as well as domestic and international, value and growth, and defensive and dynamic. Further, there are decisions to make in terms of active versus passive investments. “Some environments are better suited for active managers, and for others it makes more sense to go with an index fund. I show participants what to consider when making that decision.”

For institutional investors like Gerber, who has chaired foundation investment committees and served as a member of the Investment Advisory Committee for the New York State teachers’ pension plan, manager selection and evaluation is another level of diversification. “With institutional investments, you are dealing with multiple equity managers, and you need to diversify within that group.”

Gerber says choosing managers for an aggregate portfolio of investments shouldn’t be about finding those with the highest returns. “Once you have more than one active manager, either in the same or different asset classes, you want to make sure they are diversified and complementary. You want one to zig when the other zags. In other words, you don’t want them to win or lose at the same time. Look for the best group in aggregate so you can meet your objective with the least amount of risk. Ultimately, that is the goal of every investment portfolio.”