Friday, July 31, 2009

Portfolio Diversification and Other Myths

Van Tharp Institute
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I recently caught about five minutes of a TV program on the Loch Ness monster. So many people are still convinced that it exists! The vastness of this great body of water allows hope to spring eternal that some prehistoric or otherwise unique critter could be hiding out in the loch.

The same hope for existence is true of other mythical creatures: the yeti, Bigfoot, and successful portfolio diversification.

It’s amazing to me, really. The lengths that institutions will go to protect the status quo is astonishing.

And the vastness of the markets, much like expansive Loch Ness, serves to give people hope that myths like diversification work.

An article published by the venerable behemoth Fidelity Investments made me chuckle recently. In an effort to keep folks clinging to their “buy and hold” mutual fund strategies, they made this laughable claim: “Diversification didn't fail in the recent market downturn. It worked—just to a lesser degree.”

The downturn cited in the article was from January 2008 to February 2009 (an odd starting date for the study, but we’ll go with it). During this time period, the S&P 500 was down 48% and a “diversified” portfolio of 70% stocks, 20% bonds and 5% short term investments was “only” down 34%.

Then they looked at the brief two month period of March and April of ’09. During this time, the all-stock portfolio (an S&P 500 mutual fund) was up 19.2%, while the diversified portfolio described above was up only 11.7%.

And they claim victory from this?

In the down markets, the diversified portfolio suffered 70% of the losses, and in it only made 60% as much when the markets turned up.

This is the promise of diversification—slightly smaller losses in bad times and substantially reduced gains in good times.

The bottom line is that mutual fund companies and almost all financial advisors are stuck defending a model that is broken. Buy and Hold strategies just do not work in markets that we have seen in the past 10 years. Buy and Hold is an outdated way of managing people’s portfolios. And the mainstream retail financial community will not admit it because they have a vested interest in propagating the myths that surround Buy and Hold. They will continue to publish ludicrous articles that claim victory where none exists as long as the regulatory structure and plain old inertia keeps them clinging to a broken and outdated model.

In future articles, we’ll explore some simple and some more sophisticated alternatives to Buy and Hold. Until then...

Great Trading!

D. R. Barton

About D.R. Barton, Jr.: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at Van Tharp Institute