Diversification vs. the Siren's Song

25 years ago I wrote a book called “Navigate the Noise” that posited people have difficulty building wealth because they often follow a Sirens’ Song of high-returning yet “riskless” assets instead of following time-tested wealth-building principles. Continuing the Greek mythology theme, investors’ portfolios that steer toward the hauntingly attractive story of “riskless” high-returning assets eventually “crash on the rocks."

The Sirens’ have been singing loudly and investors are again refusing to follow sound wealth-building strategies, like diversification. Many investors today believe diversification has become “diWORSEsification”. They question the purpose to diversification when all one needed to do was trade a small group of surging stocks, i.e., the Sirens’ luring combination of high returns with no risk. Buying other assets, they felt, just added risk to a portfolio and hindered performance.

Perhaps the best example of portfolios being steered off-course is the beta of private client portfolios. At the end of January, private client investors’ largest stock holdings had an aggregate beta of an absolutely mind-boggling 1.7 (1.0 implies risk equal to the overall equity market’s risk within the context of a well-diversified portfolio). As Chart 1 highlights, that beta decreased as market volatility picked up, but investors nonetheless have started to increase portfolio beta again.

Such fervor has historically been a sign that future returns might be subpar. For example, it took NASDAQ more than a decade simply to break even after the peak of the Technology Bubble in March 2000 despite widespread adoption of the internet over that period (see Chart 2).

Large Cap Growth isn’t riskless!

Traditional risk/return analyses demonstrate today’s potential folly of believing that investing in Large Capitalization Growth stocks is a sure and safe way to invest. In fact, there are many asset classes that have shown equal and even better risk/return characteristics than Large Cap Growth.

Chart 3 is a risk/return chart based on standard deviation as a measure of risk. The upper left chart examines traditional 1-year risk/return of various asset classes, whereas the other three incorporate 3, 5, and 10-year holding periods.

Using this definition of risk under various time horizons, Large Cap Growth does provide relatively high returns, but it is actually a very risky category. The 10-year chart is perhaps most interesting because it highlights that many asset classes and sub-asset classes have historically provided similar returns to Large Cap Growth, but with varying degrees of reduced risk. Lower Quality stocks, Small Cap Value, REITs, a diversified quality basket (noted as “A+”), EM Sovereign Debt, and even an S&P 500® Index Fund provide similar long-term returns with less volatility.

Chart 4 is a similar set of risk/return analyses that defines risk as the probability of losing money rather than as the standard deviation of returns. Using this definition, Large Cap Growth has historically looked attractive on a one-year risk/return basis, but again that attractiveness dissipates as one incorporates longer time horizons.

Many academics have noted that “bad companies can make good stocks” and that conclusion is indeed supported by these charts. C&D-ranked stocks (i.e., those with considerable volatility and slower growth in earnings and dividends) have superior historical risk/return statistics in many of the charts versus Large Cap Growth.

Diversification is key but watch out for the cycle

Interestingly, some of the asset classes that provided similar or better long-term risk/return characteristics than Large Cap Growth are also those that have had relatively lower correlations to the asset class. In other words, they are perhaps the good diversifiers to a Large Cap Growth-dominated portfolio.

Chart 5 shows asset class and sub-asset class correlations to Large Cap Growth. Lower Quality stocks, Small Value, REITs, Fixed-Income, and Commodities all seem to offer meaningful diversification versus a Large Cap Growth portfolio.

Some of these diversifying equity assets are highly cyclical and might offer diversification, but they might not offer traditional defensiveness within a portfolio. We see the profits cycle potentially peaking during 2025 and have accordingly been reducing exposure to some of these equity categories. However, cyclical underperformance might offer buying opportunities for longer-term diversification.

RBA’s portfolios continue to focus on fundamentals and not the Sirens’ Song

In Greek mythology, Ulysses wanted to listen to the Sirens’ Song, but he realized he might act irrationally if he did. He put wax in his crew’s ears so they couldn’t hear the alluring melody and had the crew tie him to the mast of his ship so that he could not jump into the sea. Those prudent precautions allowed them to successfully navigate the dangerous waters.

At RBA, our disciplined process serves to keep us from listening to the Sirens and irrationally ignoring the basic building blocks of wealth building. Profits, liquidity, sentiment/valuation, and not the hyped growth story of the day, are the cornerstones of our diversified portfolios.