Broker Check

WIA BELIEVES | Why We Diversify Client Portfolios

| September 26, 2023

Uncertainty in economies and markets. Yes, much of that exists today with headlines taunting us of soft landings, hard landings, and no landings. But today I am not going to present economic and market analysis (as I sometimes do), nor any predictions (as I never do). Those who know how I feel about the overtly confident "talking head" prognosticators know that I allow my crystal ball (thoughtful research) to provide some useful guidance, but are respectful that true clarity is impossible. Therefore when allocating client accounts, rather than “place bets”, we choose to “diversify with focus”.

Diversification is primarily a risk-reduction tool and not a return-enhancement tool. It’s unfortunate that diversification is often marketed as both enhancing returns AND reducing risk because that combination rarely happens. We believe our clients both understand and have found value in the way in which we manage those trade-offs.

A well-diversified portfolio will have asset classes that have low correlation and prepare the portfolio for a broad range of unknown outcomes. Most investors have a view of the global economy and microeconomic opportunities, but what if those assessments prove incorrect? Diversification is a primary tool to both protect against being wrong in the short-term, and in the long-term to grind out solid returns.

The unfortunate reality is that today the majority of investor portfolios tend to be grossly under-diversified simply because people don’t want unattractive investments. Investors typically have a specific view and holding any investment antithetical to that view implies reducing returns. Under-diversification works well so long as the view proves correct, but portfolios tend to disappoint and have greater volatility when the incorporated, popular view proves incorrect. The 2021 post-Covid equity rally followed by the 2022 simultaneous pullback in equities and fixed-income are reflective of the carnage that can be caused in that feast or famine approach. Our portfolios have typically acted as an out-of-consensus diversifier.

Equity allocations have increased.

Risk aversion seems a thing of the past if you look at the spectrum of current investors. Investors' increase in equity allocation reflects their shift from risk aversion to risk-taking. A Bank of America Global Strategy study shows individual investors’ equity allocation was only 39% at the beginning of the bull market in 2009. Today, after 14 years of a bull market, their equity allocation is 60%. Furthermore, investors have largely started to chase the equity market’s narrow leadership and are often shunning broadly diversified portfolios to gain greater exposure to 7 mega-cap stocks (termed the “Magnificent 7” by many observers). Unknowingly for many investors who own 401(k)s and indexed investments, equity asset class returns as represented in major indices are currently very dependent on the performance of the 7 stocks.

Admittedly, the S&P 500® Index is up about 14% year-to-date, which has largely been driven by those 7 mega-cap stocks. The Magnificent 7 are up over 90% and have contributed over 70% of the S&P 500®’s year-to-date return. For comparison, the equal-weighted S&P 500® Index is up only 5% and the equal-weighted ACWI® Index is up only 3.3%.

Our research indicates that the investment opportunity in those 7 stocks seems very limited. While they are “generationally significant behemoths”, their valuations are lofty, and their profits growth is generally not superior. In contrast, we do think the menu of investment opportunities outside those 7 stocks both within the US and in the global markets could be historically broad and historically attractive.

Investors’ shift from fear to greed presents historic opportunities.

While equities as an asset class as reflected by indices might do poorly, as was the case during the lost decade of the 2000s, a rotation away from the old leadership (today just 7 stocks) could provide tremendous opportunity elsewhere. We are not so pessimistic as to believe there are only 7 growth areas in the entire global equity market. In fact, while still cautious of “headline risk” with current events, we are optimists and think possibilities are abundant.

Given that, we remain diversified in owning equities, fixed-income and alternatives, but are focusing on opportunities that are generally being ignored by most investors’ current narrow scope. In our “opportunity menu”, a short-term cash holding offers income and stability, while longer-term bonds now offer income with upside as growth and inflation soften. International stocks reduce concentration to overpriced and overhyped bubbles. In the US, companies that offer high quality with low debt and steady cash flow make sense to us, and small-cap equities have significant potential. Alternatives that take advantage of hard asset values like infrastructure, industrial materials and real estate can provide further opportunities for returns in coming months and years. Given those areas of focus, it is our job to build upon that core diversified portfolio with thoughtfully identified managers and vehicles to meet the differing needs of our clients.

Please be in touch with any questions regarding these ideas, or any other investment or planning matters that you may have. Bob and James

The views stated in this commentary are not necessarily the opinion of First Allied Securities Inc. and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed.

All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing. A diversified portfolio does not assure a profit or protect against loss in a declining market. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Additional risks are associated with international investing, such as currency fluctuations, political and economic stability, and differences in accounting standards.

For informational purposes only. These strategies may not be suitable for you. This material does not take into account your particular investment objectives, financial situation or needs and is not intended as recommendations appropriate for you. Please consult with your financial professional for the purpose of assessing whether the ideas or strategies are suitable to you based on your own personal financial objectives, needs and risk tolerance. All investments involve varying degrees of risk, including loss of principal, and there can be no assurance that any specific investment will either be suitable or profitable.

Alternative Investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. There may be conflicts of interest relating to the Alternative Investment and its service providers. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers.

For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither First Allied Securities nor any of its representatives may give legal or tax advice.