A Case Study: Diversification vs. Allocation – What’s The Difference?
John had a nice job earning a good income. His wife Denise also earned a good living and both of them were disciplined savers. Now that they were reaching their mid-50’s, their #1 focus was on socking away as much as they could for retirement, especially since their last child had just graduated from college.
With him off their payroll, they felt like they could really make some serious progress toward their goals, which had them both retiring in the next 10 years, if not sooner.
John and Denise had been investing long enough to survive the market crashes of 2000 and 2008. They got beat up pretty badly during those dark days, but with a long-term mentality in place, they rode out the storm and got rewarded in the end for their patience and discipline.
The markets had been good to them over the past 7-8 years, and while they were cautious of another nasty bear market, they felt like they had little choice other than to stay the course and hope for the best. That’s when they met us.
It’s also where the lessons I’ll be teaching you in this case study begin. As you’ll see, they did have another option available – and you do too. And by using this one simple strategy, you can significantly improve your results while putting safeguards in place to keep your money from disappearing in a market crash.
The Three-Factor Model
John and Denise shared their concerns with me and shared copies of their investment statements with me during our first meeting. I offered to review what they had and give them some feedback on how it had been doing. They accepted my offer, thinking that getting a second opinion on their plan may be helpful. They were right!
So as we began analyzing their holdings, the first thing we did was look at how they were using the 3 factors. What are the 3 factors you ask? Let us show you.
The 3 factors come from an investment pricing model developed by Nobel Laureate Eugene Fama and researcher Kenneth French, former professors at the University of Chicago Booth School of Business, in an attempt to better measure market returns. They found through their research that there were three primary factors that determined roughly 90% of an investment portfolio's behavior over time. Much of the financial media and investment community focused on market timing (when to get in and when to get out of the market) and specific investment selection (Coke vs. Pepsi or Home Depot vs. Lowes, etc.). But Fama and French found that neither of those factors weigh heavily on an investment portfolio’s outcomes in the long run.
The three factors that DO matter a lot are:
1. How much money you have in the market vs. the amount you have out of the market,
2. How much exposure you have to growth investments vs. value oriented investment, and
3. How much of your money you allocate in smaller company stocks vs. larger companies.
Let’s break these down in a little more detail:
Factor 1: Market Exposure – having more money in the market tends to increase risk and the expectation for return. The opposite is true for someone whose approach favors using non-market oriented investments. Safety is usually their primary concern with growth as a secondary interest.
Factor 2: Growth vs. Value – growth oriented investments tend to have higher growth rates, and consequently more risk, than investments with a more value oriented approach. What is a value oriented approach? Simply stated, it is one that is focused on providing a return that is made up of growth and income compared to traditional “growth only” investments that are trying to appreciate in value as much as possible. These growth companies don’t have the free cash to pay back to investors along the way. They plow that money back into their companies to hopefully make them growth even faster!
These types of growth vehicles can do very well (think Amazon, Facebook, PayPal, LinkedIn, Apple, and Microsoft, just to name a few). They make for exciting stories and unforgettable wipeouts when things don’t go as planned. They’re the ones on the cutting edge creating the new, new thing everybody wants and they get a lot of attention because of it. As long as the lights are all green for their businesses and the economy, growth investments can get you farther down the road faster than just about anything else. But, hit a slick spot on the road and they will cause you to slide farther and faster than something else going much slower. Assuming there aren’t too many of those slick spots along the way, a growth investor will take the risks and hope for the best. That can be a fool’s game – but let’s stay with our growth vs. value comparisons for now.
The value investor is looking for a company that is valued at a lower level than the growth investments trading at a multiple of what they usually are. They are often financial companies, like banks, consumer staples companies, like Johnson and Johnson, who make things we all use every day (even when the economy is bad), and other mainstream household names like Walmart and Coca Cola who are well-established leaders in mature industries. They usually pay attractive dividends and create a total return that includes that dividend and some level of growth over time. Value investments are usually less volatile in price due to both the nature of the businesses value companies are in and because of the all-weather type of stability their dividend provides to those who own them.
Value investing first became popular because of the work of a man named Benjamin Graham. He is considered the ”Father of Value Investing” and his influence has shaped the investment style of millions, including one of the richest men in the world, multi-billionaire Warren Buffett.
Factor 3: Size Premium – Fama and French discovered that the size of a company had a direct impact on both its risk and potential for future returns. Larger companies tended to have less risk overall compared to smaller companies, but smaller companies tended to have higher expected returns over time. All of the huge, high-flying tech stocks you can think of today first started out as small companies – and grew like wildfire! But, as a company grows in size, it loses its ability to execute on ideas and opportunities with the same kind of agility and speed it did when it was smaller. It’s like trying to turn a battle ship vs. a speed boat. You’re probably safer in the battle ship in a storm, but you can go faster with more flexibility in the speed boat. And depending on the circumstance, one may be better than the other - both over time and as a part of a well-diversified investment mix.
The best mix vs. the right mix
One of the great things about using the three factor model is that it doesn’t make judgments about what should and should not be a part of a person’s investment mix. It simply shows what IS there so we can begin to see what SHOULD Be there based on a person’s goals and timelines.
As you can see from the chart below, John and Denise’s investment mix showed the following three factors:
Their US Stock and Non-US Stock portion of their holdings totaled up to approximately 93% of their total portfolio. That means for the first factor, they were 93% In the market.
The next factor is found in the darker shaded boxes on the right hand side. It shows that of the 93% John and Denise have in the market, 69% of it is in large company stocks. That’s a pretty common observation since most mutual funds invest more heavily in larger companies than smaller companies. The S&P 500 that so many mutual funds use as their benchmark is made up entirely of large companies, so it’s no wonder they show up so often when we do analysis like this.
The third factor is much like the second one. Of the 93% John and Denise have in the market, 33 percent of it is tilted toward value oriented investments (as shown in the far left-hand column of the shaded boxes) compared to 32% on the far right in the growth column. Some investments are neither growth nor value. They’re kind of a blend and you can see them sitting in the middle vertical column labeled “Core.”
So at a glance, we can figure that John and Denise will probably have almost as much risk as the stock market as a whole and it’s also likely that their performance will close follow the market’s over time because so much of their stock portfolio is balance in larger stocks, just like the S&P 500 is.
Looking for more clues
Now that we understand the 3 factor model better and let’s see if those insights prove true. Here’s what their accounts look like on a risk and return basis:
“Standard Deviation” here is a measure of risk and volatility. And “Mean” is simply an average, so basically we are comparing average rates of returns and John and Denise’s average risk levels compared to a benchmark (the S&P 500 in this case) over different periods of time. The 3 and 5 year numbers are interesting, but in this case, the most valuable number to review is the 10-year number. Why is it the most important? Well, since we haven’t had a bear market in the last 5 years, the 3 and 5 year numbers only show the upside. We also need to see how this mix works in the bad times too. And our 10-year number includes the nasty bear market of 2008. You can see that in the mean portfolio returns compared to the 3 and 5 year numbers, for sure!
So, as we compare the 10-year standard deviation on the portfolio to the benchmark, we can see that John and Denise had 99% of the market’s risk and volatility over the past 10 years. That would explain why they got hurt so badly in the 2008 market crash – and why they’re concerned it may happen again unless they find a better approach that helps hedge their downside.
Their mean return is also about 99% of the market’s return, which is why they managed to recover from the big drops over time and keep their money growing. But risk more than rate of return has a lot to do with how much money you have in your accounts.
Fear the bear
When markets are going up, people don’t think as much about risk. Greed is a powerful emotion, but fear can squash greed in a flash when things are falling fast. That’s why we need to look at the worst period of time over the past 10 years to see how badly they would have suffered with their current plan.
As it turns out, the worst 1-year period and the worst 3-year period in this example overlaps due to the bear market of 2008. The stock market lost almost 50% in a 17-month period and you can see that John and Denise lost almost 42% of their savings between march of 2008 and February of 2009. That probably doesn’t represent their total loss during the bear market, but it does shine a pretty revealing light on what a difficult time it must have been for them back then.
We can also look at the worst 3-year period to see if their accounts bounced back quickly or lingered in the red for an extended period of time. As you can see with John and Denise, their 3-year average return was a -14.02 (per year) that started in March of 2006 and ran through February of 2009. Ouch!
Modern Portfolio Theory
Now that we’ve seen that John and Denise have a lot of their money in the stock market and that the risks they are taking to get market-like returns can be detrimental to their financial health at times, we have one more area to examine in our analysis. This is where the science of investing comes into the mix and shows us something we can’t really compare with any of our other tools so far – efficiency.
To truly compare an investment’s return compared to its expected return, we need to consider the way it is designed in the context of risk. In 1952, Harry Markowitz published a paper in the Journal of Finance that introduced a new theory called Modern Portfolio Theory (MPT). This revolutionary idea proposed the idea of an “efficient frontier” where the potential for investment returns are maximized and risks are minimized.
By combining investments with different attributes and relationships (correlations) to each other in terms of risk and volatility, a person could use the risks of each investment to offset the risk of another investment. In essence, by combining one investment that zigged with another that zagged at the same time, you could take mere diversification to a higher level. You could design allocated investment approaches that got better results over time without the risk associated with other, less well-engineered portfolios.
Using this knowledge of science and money, we can look at two last indicators that give us insight into how John and Denise’s portfolio is designed. The first is called Alpha and the other is called Beta. We’ll explain Beta first.
Beta in a nutshell is how closely a portfolio’s behavior is to the markets. If a person has a Beta of 1, they are perfectly correlated with the market. If stocks rise 10%, their portfolio should go up about the same amount. If stocks fall 10%, you’d expect to see about the same level of drop in the accounts too. John and Denise had Betas of between .93 and .99, which meant almost everything they had soared and plunged with the market every time it decided to move.
Alpha is an indicator that tells us how efficient an investment mix is on a risk adjusted basis. If you took a certain amount of risk, for example, and got exactly the amount of return you expected for that level of risk, your Alpha would be zero. You got exactly what you expected, so your approach was neither efficient or inefficient. It was right on the money.
If you took a certain amount of risk and made less than you had expected, your Alpha would be negative. That’s obviously not a good sign. But a positive Alpha means your accounts are generating more return with less risk – and because of that, the higher the Alpha, the better!
Alpha lets you compare one investment to another, or one investment approach to another, on a risk adjusted basis, even if you don’t know what the investments are. They are either efficient or not and Alpha tells you how you’re doing quickly and accurately.
John and Denise had negative Alphas on a 3 and 5-year basis, but by the time we get to their 10-year number, with the bad market of 2008 factored in again, their Alpha was almost exactly zero.
That confirms everything else we’ve been seeing related to risk and return and it shows us that there IS room for improvement in John and Denise’s investment portfolio. Let’s take a look now at how to get things headed in a better direction for them.
A new beginning
By having an understanding of the key indicators we’ve shown you so far, it’s easy to now make an apples to apples comparison when designing a new plan for John and Denise. As we rebalance their holdings, we can use the individual pieces to discover the most efficient place for them on the efficient frontier. That should reduce our standard deviations, increase our mean returns, lower Betas and increase Alphas. It should also reduce the damage they would see in a down market, thereby better preserving their nest egg and allowing them to recover more quickly from a bear market.
So here’s a before and after comparison in each of the areas we’ve shown you so far. And remember, for purposes of this example, gaining an understanding of the strategic concepts we share is more important than understanding all of the tactics that go into implementing them. We want you to follow the process and not get lost in the weeds trying to analyze too many details. You can contact us directly if you’d like to discuss your situation in more detail. Your particular case may be different, but this is how things worked out for John and Denise.
The 3 Factors revisited
You can see in the pie chart and in the Asset Allocation table that we pulled their amount of “in the market” money down from 93% to about 73%. That addressed Factor 1 in our 3 Factor Model. We put the some of the money into cash for now instead of bonds, since bonds have a risk of losing value as interest rates go up. And we spread the stock portion of John and Denise’s holdings out to include more value oriented companies (Factor 2) and more smaller companies (Factor 3). Both of these shifts worked together to incorporate the efficient frontier.
As we tilted the positions toward value, we reduced risk and increased John and Denise’s expected return. With a reduced level of risk in the amount of “in the market” funds and the increased amount of value investments they had, we could in turn increase the level of risk by incorporating more small companies whose movements weren't as tightly correlated as all of the large companies they owned before. The extra risks those smaller companies brought weren’t enough to tip the scales on our risk profile, but they added greater levels of expected returns and helped to reduce other risks John and Denise had otherwise.
Comparing risk and return
The restructuring we did with the investment categories altered the overall risk profile, which would naturally create an expectation of different outcomes in John and Denise’s accounts. Let’s see the before and after effects there.
As you can see from the standard deviation numbers, moving money out of the “in the market” portion of their holdings brought their risk levels down roughly 25%. But, even with less risk, their 10-year average return was well ahead of the market, pulling in over 10%/year on average for that period of time. Having less risk and more return will help their account balances grow more consistently over time, but there is a danger with this approach that catches many who aren’t prepared for it.
Look at the before and after mean return on the 3 and 5-year basis. When you have more money in stocks and stocks are headed higher, having a more balanced approach will cause you to leave some money on the table. You can sometimes feel like the train is pulling out of the station – and you’re not on it. During those times, the temptation to put more money “in the market” pushes your risk levels out of whack and leaves you exposed to losses you can’t afford to take. When you do win by speculating like this, the wins are usually never that big. But the losses can be devastating. And when things do begin to fall, you can get sucked into the mindset that you have to hang on in order to recover from your losses. If the market keeps sinking, your savings and your hopes will end up going right down with it. That’s not how smart investors operate, but like we said earlier, greed can be a very powerful emotion.
The key takeaway here is to think long-term with your investment strategy. You can’t live and die by short-term trends. There is a fine line between news and noise in the financial media. Find a game plan that works for you and keep your eyes on the prize regardless of how excited or despondent the markets get. You’re on a mission and with a well-balanced portfolio, you can stay calm in the midst of the storms. You can also avoid the fads and distractions that pull people off the path to building true wealth.
The worst of times
John and Denise got hurt pretty badly during the last bear market. Let’s see how this new allocation recipe performed during the same period.
Notice in the “After” numbers, there was still a loss during 2008-09 just like before. But losing 28% compared to almost 42% during the same period of time would have gone a long way to making them feel like they were still going to be alright. I do understand that watching your portfolio drop more than a quarter of its value in just 12 months is a painful thing to experience regardless of what the overall markets are doing. But holding your ground at a significantly better rate than others, including many professional money managers on Wall Street, does instill a sense of hope and confidence that you’re going to make it through the tough times.
The worst 3-year number in the “after” approach was not only better than the “before” scenario they lived through, it was actually positive! The “after” strategy produced a positive return of just over 4%/yr. on average, which would have really helped put them back on track faster had they known better sooner.
Bring in the science
Now that we’ve seen how risk can be reduced and how returns can be improved with an efficiently allocated approach, let’s see how the science behind the numbers shape up.
As we would have expected with less risk in the portfolio, Beta’s dropped significantly. More important than that though is the huge turnaround we see in John and Denise’s Alpha numbers. While there’s no target number to shoot for, the higher your Alpha is, the better job you’re doing maximizing returns while reducing your risks. John and Denise saw that immediately and decided it was exactly what they needed to put their fears to rest.
By implement this new allocation for them, we created a much more efficient approach and added value to their financial plan that will benefit them in both the good seasons and the bad. We know they’re coming, but now John and Denise are ready.
Wouldn’t you like to have that kind of confidence and certainly too?
But wait, there’s more
Fama And French highlighted that investors with longer time horizons will benefit most from the observations they made when formulating their 3 Factor Model. And to make things even better, they have also found in recent years that adding a 4th factor of high profitability to the equation reduces risks and increases expected returns even more. In fact, in some cases, up to 95% of behavior in a well-balanced portfolio can now be explained by these 3-4 factors alone. Try telling that to your favorite financial pundit whose job is to keep you stirred up with the latest earning news or next great pick for your retirement account!
They’re financial entertainers, not financial planners, and their job is to hold your attention so they can sell more advertisers on marketing to their audience. Is that in your best interest or in somebody’s else best interest?
So why would you follow their advice when there’s clearly a better, more personal way to get the practical insights you need to grow and preserve your wealth intelligently.
If you'd like someone to evaluate your current approach , or if you'd like to simply get a second opinion on what you’re doing now with your savings, you can request a free review with us today. We can preform the exact same type of analysis for you that helped John and Denise gain a huge advantage with their financial future. We'd be happy to share with you a full, comprehensive report that shows you exactly where you can improve your investment strategy.
We guarantee you’ve never seen anything like it – but once you do, you’ll never forget it!