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Thursday, July 24, 2014

Seeking Alph /Morningstar - The Trade-Off Between Diversification And Knowledge



The Trade-Off Between Diversification And Knowledge

Tue, Jul 22 | by Morningstar

By Samuel Lee

A version of this article was published in the July 2014 issue of Morningstar ETFInvestor. Download a complimentary copy here.

Diversification is often treated as an unalloyed good. It's not. The more I learn, the more I appreciate that Warren Buffett said something as perfect as can be about the subject: "Diversification is protection against ignorance."

Diversification is a volatility-control strategy that requires little knowledge on your part. As long as 1) two assets aren't perfectly correlated and 2) the expected return on one of the assets isn't too low, it follows as a matter of math that owning a combination of the two can be expected--not guaranteed--to provide a better volatility-adjusted pay-off than owning only one.

If you know little, diversification is a no-brainer. In fact, you want to diversify as much as possible. Moreover, you want to do it as cheaply as possible, as the benefits of diversification don't require expertise. There is a trade-off. If you know something--say, you can actually identify undervalued stocks--then at some point diversification hurts you by diluting your edge. An extreme example would be someone privy to news that's certain to send a stock's price rocketing. It would be crazy for him not to put a huge chunk of his wealth into the stock (assuming he's not breaking the law). The more you know, the more diversification hurts you.

Most investors understand that they should diversify a lot. However, some hurt themselves by behaving inconsistently: They diversify a lot while implicitly behaving as if they know a lot. A big subset of this group is investors who own lots of different expensive funds. Owning one expensive fund is a high-confidence bet on the manager. Well-done studies estimate that the percentage of truly skilled mutual fund managers is in the low single digits.

It would be strange if your process for assessing managers turns up lots and lots of skilled ones, because there aren't many in the first place. (If you see skilled managers everywhere, chances are your process is broken or not discriminating enough.) It would be even stranger if you bet on many of them. Doing so dooms you to getting index-fund-like results while paying hefty fees. It makes little sense to pay 1% or more of assets on an aggregate portfolio with hundreds of positions and market-like behavior.

An exception is if you assemble a portfolio of extremely concentrated fund managers. Owning 10 funds with 10 stocks each put together will look like a moderately concentrated fund manager. This is a model some successful endowments, hedge funds, and mutual funds use.

Most investors should own diversified, low-cost funds. Those who believe they know something should concentrate to the extent that they're confident in their own abilities. A big danger is that humans are overconfident; many will concentrate when they should be diversified.

A young investor with lots of room to make mistakes and a passion for investing should consider forming a portfolio of "play money" with a handful of his best ideas. Over time, he can learn whether he knows what he's doing and either size up or down his bets. An advantage of a concentrated "skill" portfolio is it becomes quickly apparent if an investor knows what he's doing. This can prevent a lot of heartache down the road. An older investor near or in retirement just beginning to learn about investing cannot take the risk of self-exploration. He should stick to low-cost, highly diversified funds.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.


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Seeking Alpha - To Succeed, Investors Need To Learn


To Succeed, Investors Need To Learn
Jul 22 2014, 11:12 | by Roger Nusbaum
Summary

Results from the latest DALBAR survey reports how well investors do by owning mutual funds compared to simply holding an index.
Investors need to take the time to understand how behavioral finance works in general.
Another message here is about simplicity in portfolio construction.
By Roger Nusbaum AdvisorShares ETF Strategist

The Mathematical Investor blog recapped the results from the latest DALBAR survey, which reports how well investors do by owning mutual funds compared to simply holding an index fund, no matter what happens in the market (the implication is that this is about behavioral flaws that cause people to panic-sell or panic-buy), and the results continue to not be very good.

Investors have averaged an annualized 5.02% for the last 20 years, compared to 9.22% for S&P 500 index funds.

There are at least two messages here. One has to do with investors needing to take the time to understand how behavioral finance works in general, then to gain some self-awareness of the particular cognitive errors they are most likely to make (for example, an investor is unlikely to both invest too rashly, and at the same time, suffer from analysis-paralysis).

The DALBAR results can't only be behavioral. Some amount of the lag, perhaps unquantifiable, comes from investors having to pay for life events, but most is likely from mistakes that investors make and that some investors even repeat.

Another message here is about simplicity in portfolio construction. This history of this blog, of course, is that I am a big believer in ETFs as being a meaningful part of the solution.

Seeking Alpha comments notwithstanding, it is very unlikely that a given investor will beat the market over long periods of time, but of course, with an adequate savings rate, suitable asset allocation and the self-awareness to recognize behavioral vulnerabilities an investor can have financial-plan success.

While most of this is ground we have covered before lately, the idea of being eager to continue learning has also come into the conversation.

Regardless of what direction you think interest rates are headed, after 5+ years of historically low interest rates, the fixed income market has become more complicated than it was during the thirty-whatever-year declining rate era. If you think rates are going higher, then you need to figure out how to protect your portfolio and seek alternatives like maybe liquid alternatives (on this blog, we used to just call them diversifiers). If you think rates are going to stay where they are or go lower, then you need to figure out how to generate yield from that part of the portfolio.

Both require the willingness/eagerness to keep learning. While this trait can help with healthy and successful aging, it is also necessary for both individual investors as well as financial professionals.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: To the extent that this content includes references to securities, those references do not constitute an offer or solicitation to buy, sell or hold such security. AdvisorShares is a sponsor of actively managed exchange-traded funds (ETFs) and holds positions in all of its ETFs. This document should not be considered investment advice and the information contain within should not be relied upon in assessing whether or not to invest in any products mentioned. Investment in securities carries a high degree of risk which may result in investors losing all of their invested capital. Please keep in mind that a company's past financial performance, including the performance of its share price, does not guarantee future results. To learn more about the risks with actively managed ETFs visit our website AdvisorShares.com. AdvisorShares is an SEC-registered RIA, which advises to actively managed exchange traded funds (Active ETFs). The article has been written by Roger Nusbaum, AdvisorShares ETF Strategist. We are not receiving compensation for this article, and have no business relationship with any company whose stock is mentioned in this article.


  • David at Imperial Beach
    Jul 22 07:06 PM
    Where's the rest of the article?
  • -.-
    Jul 23 09:31 AM
    Investors also need to exercise regularly to stay healthy.
  • Hardog
    Jul 24 08:47 PM
    Beating the S&P? is their time figured over investing an initial lump sum, averaging a new amount each year. ? . ,, . Note using SPY you can't reinvest. I've beat the average in most years just by DGI, of course holding WMT an dAAPL over the years has greatly helped. 

    Really tired of folks saying can't beat the index.
  • Hardog
    Jul 24 09:01 PM
    it is true ..."investors needing to take the time to understand how behavioral finance works in general, then to gain some self-awareness of the particular cognitive errors they are most likely to make (for example, an investor is unlikely to both invest too rashly, and at the same time, suffer from analysis-paralysis)."

    However Mathematicians still cannot provide the " magic Elixir" despite their complex formulas and Greek representations. I have found if one does his homework, he can find value, at the right price.
































Comments(4)
  • David at Imperial Beach
    Jul 22 07:06 PM
    Where's the rest of the article?
  • -.-
    Jul 23 09:31 AM
    Investors also need to exercise regularly to stay healthy.
  • Hardog
    Jul 24 08:47 PM
    Beating the S&P? is their time figured over investing an initial lump sum, averaging a new amount each year. ? . ,, . Note using SPY you can't reinvest. I've beat the average in most years just by DGI, of course holding WMT an dAAPL over the years has greatly helped. 

    Really tired of folks saying can't beat the index.
  • Hardog
    Jul 24 09:01 PM
    it is true ..."investors needing to take the time to understand how behavioral finance works in general, then to gain some self-awareness of the particular cognitive errors they are most likely to make (for example, an investor is unlikely to both invest too rashly, and at the same time, suffer from analysis-paralysis)."

    However Mathematicians still cannot provide the " magic Elixir" despite their complex formulas and Greek representations. I have found if one does his homework, he can find value, at the right price.
Comments(4)
  • David at Imperial Beach
    Jul 22 07:06 PM
    Where's the rest of the article?
  • -.-
    Jul 23 09:31 AM
    Investors also need to exercise regularly to stay healthy.
  • Hardog
    Jul 24 08:47 PM
    Beating the S&P? is their time figured over investing an initial lump sum, averaging a new amount each year. ? . ,, . Note using SPY you can't reinvest. I've beat the average in most years just by DGI, of course holding WMT an dAAPL over the years has greatly helped. 

    Really tired of folks saying can't beat the index.
  • Hardog
    Jul 24 09:01 PM
    it is true ..."investors needing to take the time to understand how behavioral finance works in general, then to gain some self-awareness of the particular cognitive errors they are most likely to make (for example, an investor is unlikely to both invest too rashly, and at the same time, suffer from analysis-paralysis)."

    However Mathematicians still cannot provide the " magic Elixir" despite their complex formulas and Greek representations. I have found if one does his homework, he can find value, at the right price.