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Diversification - A Free Lunch? Or a Stolen One?


Diversification has been called "the only free lunch in investing:" By investing in a basket of less-than-perfectly correlated assets, an investor can reduce the volatility of their portfolio without a proportional drop in its expected return (insert Charlie Brown teacher squawking here for some readers, I'm sure).  This theory, developed by Harry Markowitz, is the central foundation of Modern Portfolio Theory and the one most financial advisors use in developing client portfolios.


So, why has diversification felt more like a stolen lunch than a free lunch the last 15 years?  I mean U.S. large cap stocks, particularly technology stocks, have absolutely demolished (in terms of returns) international stocks, emerging markets, and small cap equities for a long time now.  I make no apology, most of our clients have been invested in at least some underperforming asset classes for years now.  And we've watched as artificial intelligence stocks like Nvidia and Super Micro Computer have taken off in the last year.  


I'll be honest, it's been tough to watch as a 100% U.S. large cap allocation has for years now bested what Modern Portfolio Theory says a good and responsible fiduciary advisor ought to do (i.e. diversify).  The groans from my friends and colleagues who 100% subscribe to this method are growing louder by the day. That said, at Flatirons Wealth Management, we understand the difference between a "theory" and a "fact."  And Modern Portfolio Theory is just that, a theory.  A theory is not a fact.  It is an explanation of one or more facts.  A well-supported evidence-based theory becomes acceptable until disproved.  It never evolves to a fact, because then it would be a fact.  Perhaps what we're seeing now, and for the last 15 years, is Modern Portfolio Theory being disproved.  I don't know if that's the case, but I'm open to the idea.  Indeed, as I've also shown in the past and continue to show, I'm open to the idea that the market gives "hints" as to when a bottom (or top) may be at hand and that sometimes buying an individual stock or three can greatly help portfolio returns.  Indeed, subscribing to these theories has served us quite well the last few years.  


Ultimately, what matters is not how well the portfolio performs compared to the best or worst asset classes in any given time, but how well it works toward achieving the investor's goals and, to my mind, how it performs against an appropriate overall benchmark.  That's why I'm constantly evaluating and re-evaluating whether or not my process is working.  Because if an investor needs a 7% average return to successfully save for retirement and their portfolio achieves that goal (or more), there's little point in losing sleep over the one investment that returned 10% (or 100%).  Instead, the main challenge of investing in a diversified portfolio isn't the diversification itself, but rather dealing with the disappointment that there's a better performing asset class somewhere, and staying focused on the strategy that will prove "good enough" to reach the investor's goals over the long run.

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