Article Commentary: The Two Least Understood Investment Rules that Most Hurt 401K Investors By: Gabriel PotterMBA, AIFA® 2013.04.23

We have been discussing this article on Fiduciary News in our office.

Not only because we provided material for the article, but we’ve also been interested in the perspective of the author as well as the other contributors. 

The theme of the article is over diversification in a portfolio, both on a fund level and a portfolio level.  To review, the central argument for diversification is:  by selecting optimal combinations of non-correlated assets, an investor can maximize their return for any given level of volatility risk.  The key here is low-correlation:  ideally, an investor should have a combination of assets that move in different directions.  So, for a simple example, you might like to have a Treasury bonds that increase in value even if the stock market is tanking.  (In other words, you’d like some assets that “zig” while your other assets “zag.”)

The article takes a different tack.  Regarding individual funds,  the author first advocates for mutual funds that are distinctly more concentrated then peers, arguing that the optimal size is 30-50 stocks.  On the portfolio level, the author notes that, in times of market stress, the correlations between asset classes converge and the so-called benefits of diversification get muted. 

He has a point.  Certainly, we’ve discussed some of the illusory benefits of diversification – both in the article itself - as well as some of our own white papers.  But, we can acknowledge the truth of the point and still add levels of nuance to it. 

For example, a fair amount of the article discusses the “one portfolio” approach, often enacted via a target date solution. It has been noted that target date fund solutions are often funds of underlying mutual funds which tend to generate passive like performance at active management fees.  On the other hand, it’s worth noting that other target date funds are at least nominally aware of these pratfalls and have their own approach to it.  First, some investment managers do not merely combine a fund of funds but individually select traditional assets (stocks and bonds) to generate what they believe are optimum portfolios.  Second, there is a middle ground, wherein investment managers maintain a high number of traditional positions (or even funds) to take advantage of asset allocation modeling, but maintain derivatives (e.g. – “put options” on the S&P 500) to offset large losses when the entire market turns negative and correlations of different asset classes converge.   Third, some investment managers completely agree with the underlying thesis:  fine tuned asset allocation is futile. Thus, any assets which could exhibit high correlations during high stress market environments get reclassified as “global equities” and the residual satellites of assets are concentrated into positions specifically selected to behave differently. 

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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