Diversification vs. Dispersification (October 2010)

Written by Dominick Paoloni

An individual looking for a money manager recently walked into my office to learn about my investment philosophy. The first thing he said to me is, “If I hear one more word about diversification I’m going to scream.” Apparently the many money managers he had interviewed all spoke of diversification as the secret to investing. After getting a chuckle from his interviewing experience, I told him the secret to investing is in fact diversification and that I frequently talk about the subject in great detail.

Most financial professionals talk about diversification the way many health care professionals preach about a healthy diet before they waddle over to McDonalds for a Big Mac.

I have found in my many years as a financial professional that “diversification” and “asset allocation” are the most overused phrases in finance and the least understood concepts. The general concept of diversification is based on investing in different assets to reduce the risk inherent in your individual investment positions. This will presumably smooth out the volatile ups and downs of investing and provide the investor a consistent positive glide path to retirement.

The problem arises when this basic concept is applied without understanding the complex nature of correlation, the cornerstone of building a truly diversified portfolio. Most of the portfolios that I examine over these many years are “dispersified” not diversified. “Dispersification” is the false perception of diversification. Many investors in 2008 complained that they took huge losses even though they were diversified. One investor went so far as to show me his pie chart with the many different colors denoting different investment asset classes.

True diversification is born from the Nobel Prize-winning work of Dr. Markowitz. According to Dr. Markowitz, diversification is achieved by investing in assets with low or no correlation to other assets in the portfolio, which in turn reduces risk more than it limits return. In other words, diversification is when different assets within the portfolio measurably move in different directions.

You can think of correlation as the measurement of how much assets move together. Imagine a school of fish in the ocean. Each individual fish represents a different investment. You may think you are diversified because you have so many holdings, yet the whole school moves in the same direction as if they were the same fish. Those fish have a high correlation. Now imagine a dolphin, representing another investment in your portfolio. The dolphin moves independently of the school of fish, and the movement of one has very little impact on the movement of the other. A dolphin has very low or no correlation to the fish.

Measuring the relationship of each asset in the portfolio to all the other assets in the portfolio is just the first step. The correlations are always changing as economic conditions change, and must therefore be monitored on a continual basis. Many investors that were diversified going into the 4th quarter of 2007 became less and less diversified throughout 2008 as changing economic conditions caused the positions within their portfolio to become more and more correlated with each other.  By October 2008 most portfolios were as diversified as a school of fish.

However, investors looked at the different asset classes represented in their portfolio and believed they were diversified. While the dolphin and the school of fish typically have low correlation, if a shark suddenly appears the dolphin may move in the same direction as the fish for awhile to escape the shark. An external factor caused low or non-correlated fish (investments) to become highly correlated. You are no longer truly diversified.

The process of true diversification is far more difficult than throwing individual assets into a pie chart.  Dr. Robert Engles won the Nobel Prize in 2003 for his innovative work on Dynamic Conditional Correlation, in which one continually anticipates and responds to correlation shifts to keep a portfolio truly diversified. This is a major factor in IPS’s consistent portfolio performance over these many years as a premier risk-based money management firm.  Unfortunately many people not with IPS lost a lot of money because they relied on a pie chart rather than correlation to demonstrate diversification.  Mark Twain once said “It ain’t what you don’t know that will hurt you, it’s what you think you know that ain’t so.” Truer words have never been spoken.

*This article is not a recommendation to buy or sell and should not be considered investment advice. Please consult IPS or another financial advisor before making any investment decisions.