For years, many advisors have touted that diversification (a wide range of investments) is the only way to optimize investing. But in recent markets, has diversification prevailed over concentration (a focused and selected group of investments)?
“The idea of excessive diversification is madness. Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.” – Charlie Munger of Berkshire Hathaway
For reference, below is a chart of the trade range in the market over the last year for the New York Stock Exchange provided by Yahoo Finance.
It's clear to see why year-to-date returns may be scary. January was a high-water mark for our most recent trade range. But when we dig deeper and look at the market over the last rolling year, the year-to-date numbers feel less intimidating. Currently, the NYSE is near the closing price average over the last year.
But what does that mean for investors? The answer to that question will vary greatly based on the approach of your investment advisor. For this case study, we will examine the difference between diversification (modern portfolio theory) and concentration (one component of the Anew Advisors investment philosophy).
Modern Portfolio Theory - Diversification
The portfolio examined contained eighteen different mutual funds and ETFs and was constructed using modern portfolio theory. As expected, there is a theme of overlap and over-diversification. Like many modern portfolio theory portfolios, when you hold a large cap index fund, and multiple large cap growth and value funds, you are bound to overlap in both good and bad securities.
One example of overlap was Microsoft being held in five different mutual funds within one portfolio. Therefore it's being paid for five different ways with five different fees.
Another issue that needs to be discussed is bonds. Not only do we see the same overlap issues we do in securities, but modern portfolio theory tends to over-allocate to bonds. When interest rates and inflation are rising, bond holdings are potentially more dangerous to portfolio returns than stock holdings.
As a rule of thumb, when interest rates rise, bond prices decrease. So when the Fed raises interest rates, bond fund returns will likely suffer. The faster rates rise, the quicker bonds prices can fall. Inflation is also detrimental to bond holding. Say you have a bond paying 3% with a duration of four years. With a conservative inflation rate of 4% in 2022, you lose 1% in purchasing power.
Modern portfolio theory all but dictates that a portion of your portfolio be allocated to bonds. If an advisor believes you have a “low-risk tolerance” or close to retirement they will likely move more of your money into bonds. The likely effect on the portfolio will be the “safer” investments being down near what stocks are down year-to-date and the recovery will likely be less than what is seen with stocks.
Anew Advisors Investment Philosophy – Concentration
Anew Advisors’s investment philosophy concentrates its investment selection on three key criteria: purchasing individual company securities that pay a dividend and provide their goods and services to baby boomers or millennials. With no transaction costs or overlap, our portfolio is likely to be more efficient than portfolios created based on modern portfolio theory.
Historically, organizations that offered and grew dividends provided exponentially larger returns than non-dividend stocks. When organizations start cutting dividends, that typically signifies rougher waters ahead. We don’t want to stick around to see what that means and prefer to remove stocks from our portfolio when they stop providing dividends.
The individuals who will control the market for the next 50 years have already been born. Baby boomers and millennials make up the majority of the decision-making population. As millennials grow up and progress in their careers and lives, they will consume goods and services just like previous generations. As a result, it’s critical for stocks we invest in to serve one or both audiences.
Currently, our portfolios do not contain any bonds. With the current interest rate environment and rising inflation, we do not believe that it is prudent to purchase new bonds. Especially with the added costs of purchases through mutual funds.
Diversification vs. Concentration
Comparing the two approaches apples to apples can be difficult because we can't speak to the advisory fee of the diversified portfolio. Therefore, the diversified portfolio will have an advantage when comparing statistics. We measured their returns using a 0% advisor fee, vs. the Anew Advisor cost of 1.00%, and the investment management cost of .70% in our portfolio. All statistics are calculated net of costs.
The chart above compares the characteristics and relative statistics for the two investment approaches. All performance data and risk statistics are as of April 4th, 2022**. The portfolio built on modern portfolio theory has a mix of stocks and bonds with a negative cash allocation likely based on securities lending within some of the selected funds and ETFs vs. Anew’s portfolio of stocks with a small allocation to cash for future needs.
What the statistics show is how the returns and risk of each portfolio compare*. Over the year-to-date, one-year, and three-year period, Anew Advisors has out performed the modern portfolio theory portfolio and has done so with only taking slightly higher risk illustrating the drag of bonds on portfolio returns without a significant reduction in risk.
For the Anew Advisors philosophy, the dividend-paying stocks have done exactly what they should in corrective markets: stabilize the portfolio*. With a risk only slightly higher than a portfolio containing “safer” bond investments the Anew Advisors portfolio is down less YTD and up more over the last year. For most of the portfolios with Anew Advisors, dividends are also reinvesting and buying more shares through the lows of the current cycle. Therefore, over the long term, when the market does turn, there will be more shares to grow.
To see how your portfolio might compare to one of Anew Advisors' portfolios, schedule your consultation and roadmap review with our team.
*full report and portfolio performance available upon request
** YTD from January 1st, 2022 to April 4th, 2022.
Anew Advisors, LLC (“Anew Advisors”) is a Registered Investment Advisor ("RIA") registered with the state of Wisconsin. The content of this communication has not been approved or verified by the United States Securities and Exchange Commission or by any state securities authority.
The information contained in this material is intended to provide general information about Anew Advisors and its services. It is not intended to offer investment advice. Investment advice will only be given after a client engages our services by executing the appropriate investment services agreement. Information regarding investment products and services are provided solely to read about our investment philosophy and our strategies. You should not rely on any information provided on our web site in making investment decisions.
There is risk in ALL Investing. Past performance is never a guarantee of any future return. All investing can result in a loss. Consult with your Advisor before making any investment decisions. This is not an offer to buy or sell a security in any jurisdiction.
Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown.
Market data, articles and other content in this material are based on generally-available information and are believed to be reliable. Anew Advisors does not guarantee the accuracy of the information contained in this material.