Why Diversification Doesn’t Always Mitigate Risk

NEW YORK (TheStreet) -- These days, it's clear that balancing a portfolio's exposure to different asset classes provides the potential for winning investments across various market conditions.

However, I say it's delusional to think a colorful, balanced asset-class-based pie chart equates to sensible level of risk assumption. No matter how many asset classes are represented, your portfolio may still be riskier than you think.

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Is this heresy? No, it's an evolution in thinking since Harry Markowitz demonstrated the power of diversification in the early 1950s and it represents a more sophisticated approach to investing.

Asset Classes

Asset classes -- stocks, bonds, and what have you -- are simply legal definitions and nothing more. The classic example of the failure of asset class diversification is the Lehman Brother's employee who held a mix of stocks, options and bonds -- all in one company that failed spectacularly.

Even modern investors can inadvertently fall into this trap. Imagine the Google (GOOGL) employee with valuable stock and options in the owner of the world's largest search engine. Let's say that person has diversified into stock, bond and index funds choosing, for example, Davis New York Venture Fund (NYVTX), Vanguard Intermediate-term Corporate Bond Fund (VCIT) and Vanguard 500 Index Fund (VFINX).

Davis holds positions in both Google Class A (7.85% net assets) as well as a stake Google Class C Stocks. Vanguard's Intermediate Corporate Bond Fund and its 500 Index fund also hold stakes in Google. However, this is only isolating one type of risk.

Risk Types

You achieve effective diversification by diversifying across the four major sources of underlying sources of risk: (1) company risk, (2) interest rate risk, (3) purchasing power risk and (4) manager skill risk. Allocating to risks, as opposed to asset classes, is how many institutional investors chose to build their portfolios.

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Each risk exerts itself differently depending on the economic environment. Losses associated with one risk can be offset with gains associated with another. For instance, in the hypothetical Google example, company risk can be mitigated through buying equities and/or corporate bonds to dilute the Google share of the portfolio; interest rate risk can be eased buying the sovereign bonds of the US or other developed countries.

Purchasing power risk can be reduced through the use of numerous financial products which offer the ability to purchase inflation protection. Even the Treasury offers Inflation Protected Securities (TIPS). You can review manager skill risk by checking if actively-managed accounts purchased in the past are still being handled by the manager you started with or someone of equal skill. Furthermore, you should diversify among managers with different strategies.

Some investment managers espouse equal weighting to each of the different risks, called risk parity. In my opinion, however, it is not always prudent to have a constant weighting to each source of risk. Tactically changing allocations to reflect the opportunities or risks in the market may benefit your portfolio.

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Of course, there is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. How you approach such diversification, however, is vitally important. If you want to look at your portfolio with fresh eyes, consider examining it from a risk diversification perspective.

At the time of publication, the author held no positions in any of the stocks mentioned, although positions may change at any time.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

TheStreet Ratings team rates GOOGLE INC as a Hold with a ratings score of C. TheStreet Ratings Team has this to say about their recommendation:

"We rate GOOGLE INC (GOOGL) a HOLD. The primary factors that have impacted our rating are mixed ? some indicating strength, some showing weaknesses, with little evidence to justify the expectation of either a positive or negative performance for this stock relative to most other stocks. The company's strengths can be seen in multiple areas, such as its revenue growth, largely solid financial position with reasonable debt levels by most measures and reasonable valuation levels. However, as a counter to these strengths, we also find weaknesses including a generally disappointing performance in the stock itself, disappointing return on equity and feeble growth in the company's earnings per share."

Highlights from the analysis by TheStreet Ratings Team goes as follows:

  • GOOGL's revenue growth has slightly outpaced the industry average of 11.5%. Since the same quarter one year prior, revenues rose by 13.1%. This growth in revenue does not appear to have trickled down to the company's bottom line, displayed by a decline in earnings per share.
  • Although GOOGL's debt-to-equity ratio of 0.05 is very low, it is currently higher than that of the industry average. Along with this, the company maintains a quick ratio of 4.14, which clearly demonstrates the ability to cover short-term cash needs.
  • The gross profit margin for GOOGLE INC is rather high; currently it is at 63.35%. Regardless of GOOGL's high profit margin, it has managed to decrease from the same period last year. Despite the mixed results of the gross profit margin, the net profit margin of 21.44% trails the industry average.
  • Despite any intermediate fluctuations, we have only bad news to report on this stock's performance over the last year: it has tumbled by 33.22%, worse than the S&P 500's performance. Consistent with the plunge in the stock price, the company's earnings per share are down 32.58% compared to the year-earlier quarter. Naturally, the overall market trend is bound to be a significant factor. However, in one sense, the stock's sharp decline last year is a positive for future investors, making it cheaper (in proportion to its earnings over the past year) than most other stocks in its industry. But due to other concerns, we feel the stock is still not a good buy right now.
  • The company's current return on equity has slightly decreased from the same quarter one year prior. This implies a minor weakness in the organization. Compared to other companies in the Internet Software & Services industry and the overall market on the basis of return on equity, GOOGLE INC has outperformed in comparison with the industry average, but has underperformed when compared to that of the S&P 500.

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