Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Investors have had some interesting things to say during the ongoing financial crisis. “My previous advisor had me well diversified,” several new clients have told us, “but my portfolio still lost almost forty percent of its value.” Unfortunately, during a systemic breakdown like the global financial crisis, diversification is not enough to insulate investors from heavy losses.
In the future world of slower growth and lower returns, “There are three things that every investor needs to get right,” said Mohamed El-Erian, co-CEO of PIMCO, in a recent interview with Jason Stipp of Morningstar. “The first thing is a forward-looking asset allocation—not a backward-looking asset allocation, but an asset allocation that makes sense in ‘The New Normal.’ Secondly, finding the vehicles that are stable enough to express that allocation. And, thirdly, risk-management.”
El-Erian said it is not enough to be diversified. Diversification is absolutely necessary, but it’s not sufficient. He believes investors must look at other elements of risk management in order to navigate in times of lower returns and potentially higher volatility.
The mainstream financial services industry, the media and academia—virtually everyone—has overestimated the value of diversification in risk management. The recent crisis has shown that investors need more than simple diversification to protect them from both the known and the unknown risk that they will eventually encounter. When it comes to risk management, diversification simply is not enough.
Who’s watching the kids?
There are three basic types of risk to a stock investor’s portfolio:
- Company Risk: the risk that a specific company will have a problem
- Sector Risk: the risk that an industry sector will have a problem
- Market Risk: the risk that the overall market will have a problem
Diversification is an obvious way to attempt to mitigate these risks. But, ironically, if you ask an investor on the street, “Who manages the risk in your mutual funds?” they will probably tell you, “The fund manager.” Ask the fund manager what his job is and he will tell you, “I’m paid to pick stocks. Risk management is handled at the portfolio level, not the fund level.” The irony is that each party thinks the other is doing the risk management, but neither actually is.
Mutual fund managers are evaluated by how well they perform versus their benchmark. The S&P 500 fell over 56% during the recent crisis, so if your large-cap mutual fund lost 50%, according to conventional thinking, you owned a great fund. If you were really lucky, maybe you were invested with Morningstar’s Domestic-Stock Manager of the Year for 2008. Charlie Dreifus, who manages the Royce Special Equity Mutual Fund, kept his losses to 40.5% between October 9, 2007 and March 9, 2009 while his benchmark, the S&P 500, tumbled 56.8%. During the worst of the crisis, even “the best” mutual fund managers in America suffered huge losses.
