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The Myth Of Diversification & The Risk Of “Psychological Leverage”

Written by David Robertson | Dec 19, 2018

Every once in a while it can be helpful to take a step back from frenetic daily routines, to revisit assumptions and beliefs, and to just experience things afresh. Watch a good movie that you haven’t seen for a while or re-read a book and new details will emerge. There might be entire scenes you don’t remember very well that enhance the richness of the narrative. The experience can be enjoyable, even enlightening.

The same case can be made for revisiting investment principles and this is exactly what three different pieces of recent research do. Some insights are new. Some are useful reminders. All are relevant for investors who are navigating difficult markets.

The first body of research comprises two papers [here] and [here] by Edward F. McQuarrie, Professor Emeritus at Santa Clara University. Working with data collected by Richard Sylla (co-author of A History of Interest Rates), Jack Wilson, and Robert Wright, McQuarrie expands the range of holding period returns for bonds to the 1793-1857 period. With this, he significantly expands the historical perspective of asset returns and opens the door to a fresh interpretation of it.

His simple summary of the new bond return data is:

“1) returns for the period were well above the long-term average cited by Siegel (2014); 2) bonds are as subject to bull and bear markets as stocks; 3) bond returns can be depressed or super-charged over periods decades in length.”

Indeed, the chart “The First Fifty Years of the US Stock and Bond Markets” shows a striking similarity between stocks and bonds.

With the added perspective of the new data, McQuarrie also endeavors to take a fresh look at the value proposition of stocks in a portfolio. As McQuarrie describes:

“The goal is to challenge shibboleths about the expected outcomes of buy-and-hold stock market investing, and to raise questions about the expected performance of stocks versus bonds over long periods.”

Grant’s Interest Rate Observer, which noted the papers in both its November 16, 2018 and November 30, 2018 editions, describes one shibboleth:

“The [Jeremy] Siegel thesis animates (if not enslaves) many a stock-market dip-buyer, retirement planner and endowment-fund trustee. If there were such a thing as Street writ, it would run something like this: ‘Equities never disappoint in relation to bonds and cash over a multi-decade holding period’.”

The implication, as Grants notes, is:

“If McQuarrie is right, as we believe him to be, Wall Street has some explaining to do—certitudes to discard, expectations to reset, portfolios to re-build.”

As a result of the data work, McQuarrie adds valuable perspective to the history of stock and bond returns. For certain, he reports:

“There remains an important asymmetry: the much greater volatility of stocks relative to bonds. Stocks can go up much faster and reach much higher peaks than bonds. But this fact only helps investors who are capable of market timing: investors who know how to get out at the top, before the flip side of volatility takes hold, and stocks plunge further and faster than investment grade bonds ever could.”

This perspective paints the value proposition of stocks (relative to bonds) as far less alluring than many believe. Specifically, McQuarrie reports:

“There are also almost a dozen cases of negative equity premia, lasting for as long as forty years. Collectively, these periods of rough equivalence (between stocks and bonds) cover about two-thirds of the 210 years. The best one sentence summary of the 210 year record would be that sometimes, stocks outperformed bonds, but at other times, bonds out-performed stocks; while much of the time, stocks and bonds performed about the same.”

The second piece of research addresses the issue of diversification. Sébastien Page, CFA and Robert A. Panariello, CFA tackle an important investment challenge in the Financial Analysts Journal [here]:

“One of the most vexing problems in investment management is that diversification seems to disappear when investors need it the most. Studies have shown this effect [the disappearance of diversification benefits] to be pervasive for a large variety of financial assets, including individual stocks, country equity markets, global equity industries, hedge funds, currencies, and international bond markets.”

Even though “most of these studies were published before the 2008 global financial crisis,” the authors highlight the fact that, “the failure of diversification during the crisis … seemed to surprise investors.”

Under the heading, “The myth of diversification”, Page and Panariello remind investors:

“Leibowitz and Bova (2009) showed that during the 2008 global financial crisis, a portfolio diversified across US stocks, US bonds, international stocks, emerging market stocks, and REITs saw its equity beta rise from 0.65 to 0.95.”

In other words, a portfolio consisting of the types of assets that comprise the vast majority of many portfolios saw diversification benefits fall to almost zero in the heat of the crisis. The authors state bluntly:

“Diversification fails across styles, sizes, geographies and alternative assets!”

This is interesting partly because some asset allocators employ alternative assets explicitly for the purpose of increasing diversification. It certainly makes a good story because it is intuitively obvious that hedge funds would be hedged. Indeed, the authors recognize such efforts:

“Beyond traditional asset classes, investors have increasingly looked to alternatives for new or specialized sources of diversification.” 

The evidence refutes the intuition, however:

[A]ll the styles [seven different hedge funds styles were examined], including the market-neutral funds, exhibit significantly higher left-tail than right-tail correlations.”

The same results hold for private equity:

“Pedersen, Page, and He (2014) showed that the private assets’ diversification advantage is almost entirely illusory.”

To be sure, Page and Panariello “are not arguing against diversification across traditional asset classes.” They do make clear, however:

“[I]nvestors should be aware that traditional measures of diversification may belie exposure to loss in times of stress.”

In other words, it’s not a good idea to rely exclusively on diversification as a risk management tool.

Yet another piece of research dovetails nicely with the preceding two. Eugene Fama and Kenneth French report [here],

“The high volatility of stock returns is common knowledge, but many professional investors seem unaware of its implications. Negative equity premiums and negative premiums of value and small stock returns relative to market are commonplace for 3- to 5-year periods; and they are far from rare for 10-year periods.”

One interesting aspect of each of these pieces of research is that they come from very credible sources. Fama, for example, won the Nobel prize for economics for his work on portfolio theory, asset pricing and the efficient market hypothesis. In fact, one would be hard-pressed to find any single person more responsible for conventional finance theory.

Another interesting aspect is that none of the pieces is cutting edge research per se. This is not at all to disparage the efforts, but rather to recognize that each of them treads on a great deal of familiar territory. Collectively, they beg the question: Why revisit these topics now?

Gillian Tett describes one possible explanation in the FT [here]. She notes that Seth Klarman from Baupost Group is intrigued by the concept of “psychological leverage” which is described as:

“A situation in which everybody is so heavily invested in the assumption that markets will move in one way that a small reversal can spark a self-reinforcing panic.”

This is fairly consistent with the view of Ray Dalio, founder of Bridgewater fund, who assessed:

“The world by and large is leveraged long. When there is a downturn, I don’t think there’s much to protect investors.”

In other words, it appears as if investors have become habituated to taking on risk. After all, the financial crisis was ten years ago. Comforted by the passage of time and by recency bias (the tendency to place too much emphasis on things that have happened recently and not enough on those that happened longer ago), many investors have brushed off the financial crisis as an aberration.

This tendency is also exacerbated by the growing number of investors who have never experienced the visceral fear of a financial crisis. Terry Duffy, chief executive of the Chicago Mercantile Exchange, noted:

“Seventy-one million people in America are millennials and never saw a downtick in their lives. So if the market wobbles they don’t know how to handle it, particularly since information moves so fast.” 

Further, as James Montier has described, too many investors will not be able to rely on their providers when the going gets tough. Back in the heat of the financial crisis he stated unequivocally in the FT [here],

“New research shows that career risk (losing your job) and business risk (losing funds under management) are the prime drivers of most professional investors. They don’t even try to outperform.”

Nor do they guard against material losses if that effort conflicts with career risk or business risk.

As a result, it will largely be up to investors and conscientious advisers to ensure that investment decisions are made with the full breadth of insights and resources available. Fortunately, each of the three pieces of research provide useful suggestions.

The lesson from McQuarrie is straightforward: The conventional focus on asset returns from the post-1926 era is misleading and misleading in a way that is especially harmful for retirees. The reason is, as McQuarrie points out:

“The twentieth century US data, especially following WW II when the US economy bestrode the world as a colossus, paints a very sunny picture for stocks, and a sad cloudy picture for bonds, memorialized in Siegel (2014).”

As it turns out, this period is more the exception than the rule.

The broader context of history paints a cloudier picture not just for stock returns, but even more importantly, for the probability that stocks will outperform bonds. The issue is that even though a prototypical investment horizon of forty years is a long time, it’s not nearly long enough to guarantee the benefits of excess stock returns.

In fact, with the 210 year history of US capital markets as a guide, investors can expect stocks to outperform bonds less than half the time. Performance for stocks and bonds was comparable in several multi decade periods  As it turns out, equities do disappoint in relation to bonds over multi decade holding periods.

So, one important takeaway for those who are investing for retirement is to temper expectations for both the total return of stocks and the likelihood of excess returns of stocks versus bonds over the course of their investment horizon.

Likewise, the work by Page and Panariello provides useful lessons as well. While many investors and advisors take comfort from the practice of diversification to weather storms, Page and Panariello suggest:

“[I]nvestors should look beyond diversification to manage portfolio risk.” At very least, they recommend, “Scenario analysis, either historical or forward looking, should take a bigger role in asset allocation than it does. Significant emphasis should be put on the stock-bond correlation and consideration of whether it will continue to be negative in the future. Shocks to interest rates or inflation can turn this correlation positive.”

Further, as McQuarrie illustrated, there absolutely have been periods of time in which stocks and bonds are positively correlated.

If/when investors observe the potential increase for interest rate or inflationary shocks, they can prepare by de-risking the portfolio by raising cash or by employing any of several tail risk hedging or dynamic risk management strategies.

Finally, Fama and French conclude their paper in fairly straightforward terms as well:

“The high volatility of monthly stock returns and premiums means that for the three- and five-year periods used by many professional investors to evaluate asset allocations, the probabilities that premiums are negative on a purely chance basis are substantial, and they are nontrivial even for 10- and 20-year periods.”

In other words, investors should do what professional investors do not do: accept that there is a great deal of uncertainty in returns and moderate views in a way that is commensurate with the level of uncertainty.

Taking a step back by reviewing these research pieces reveals that much of what passes for conventional investment advice needs to be updated. Stocks are not the “no-brainer” decision for retirement plans that they are made out to be. Diversification often fails which requires more active and dynamic risk management. It is very hard to disentangle skill from luck and decisions should reflect that uncertainty. As such, there absolutely are “certitudes to discard, expectations to reset, portfolios to re-build.”

Taking a step back also serves another purpose which is to shine a bright light on the investment industry itself. It is odd that three different pieces of research would each revisit familiar investment theory. It is also strange that highly reputable academics such as Fama and French would go to the effort of calling out “many professional investors” for being unaware of the implications of “common knowledge”. Finally, it is odd that it takes a retired marketing professor to meaningfully expand the database of asset returns and to objectively interpret the expanded series.

Perhaps, just perhaps, the business risk and career risk of many investment professionals has become so enmeshed with “psychological leverage” that they are not really capable of taking a step back and re-evaluating what is best for their clients. If this is true, a similar set of changes could also be in store for the investment services industry — with certitudes to discard, expectations to reset, and businesses to re-build.


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David Robertson CFA is the CEO of Areté Asset Management and founded Areté with the mission of helping people to get the most out of their investing activities. Most of his career has focused on researching stocks and markets, valuing securities, and managing portfolios for mutual funds, institutional accounts, and individuals. He has a BA in math from Grinnell College and a Masters of Management from the Kellogg School of Management at Northwestern University. Follow Dave on LinkedIn and Twitter.

2018/12/19
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