Why smart money seeks “broad diversification”

Why smart money seeks “broad diversification”
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In our last blog post we showed that green investors who keep most or all of their capital in just the largest US sustainable companies may pay a high price due to lower diversification and missed opportunity.

For example, one dollar invested in just large US companies (S&P 500 Index) in 1970 would have been worth $100 on New Year’s Eve 2016. A very nice return, which could have been much better. The same dollar would have been worth $400 if invested in the Global Diversified Equity Strategy Index.

Combining diverse financial assets in a globally diversified portfolio can be less risky and achieve higher returns than putting all your investment eggs in one basket (e.g. large US companies only).

In the words of Nobel Prize winner Merton Miller: Diversification is your buddy.

 

Why broad diversification may prevent you from missing opportunity

 

Attempting to identify a group of future winners is a guessing game. This is a key reason why more than 80% of actively managed equity mutual funds underperformed the market over the past 15 years. By picking a small subset of possible investments, they are likely to miss out on many of the top performers.

Why is this so important? Because the top performers make up a disproportionate amount of overall market gains. A given investment can only go down by 100%, but it can go up by 500% or more. This allows the best performing investments to more than compensate for many bad performers.

Here’s a case in point: From 1994 to 2016 a portfolio of all global stocks returned 7.3% per year. But if you missed out on the best performing 10% of stocks, the return declines to 2.9%. If you missed out on the best performing 25%, the return declines to -5.2%.
 

Compound average annual returns: 1994-2016

Source: Dimensional Fund Advisors1

 

If you knew in advance which the top performing securities or sectors would be, you would of course realize excellent returns. Unfortunately, as evidenced by the poor results of actively managed funds, there’s no reliable and persistent way to do so. But by holding a broadly diversified global portfolio, investors are well positioned to capture returns wherever they occur – and smooth out some of the bumps in the road. With greater peace of mind.
 

What do you mean by “broad diversification”?

 


 

Passive management and factor investing — unlike sector funds or active management — typically leverage broad diversification to reduce risk and position your portfolio to capture the returns of broad economic forces.

Broadly diversified” funds hold thousands of stocks across the entire eligible universe of companies from different countries, continents, industries, size, value vs. growth — in both developed and emerging markets.

The S&P 500 itself, which many green funds use as a benchmark, does not constitute a broadly diversified portfolio in terms of either domestic or global exposure. This is because it only covers large companies, and only those in the US. By contrast, the MSCI World Index, a common benchmark for broad diversification, constitutes 46 countries, nearly 9,000 stocks and a wide variety of companies – small to large, growth and value.
 

Are 200 stocks enough to be “diversified”?

The short answer is “no”. Research shows that a small basket of stocks (say, 50 to 200) would require significantly higher expected returns to match the risk-adjusted returns of a broad market index. This is true even for a relatively small universe of stocks like large US companies (about 1,000).

Given prior experience, there is very little certainty that any given stock selection strategy will accomplish that goal. The larger the universe – e.g. the nearly 9,000-stock MSCI World Index – the larger your portfolio should be to capture the returns of broad economic forces and reduce the inevitable bumps in the road.
 

Holding Fewer Names in a Portfolio Increases Tracking Error

Average Monthly Tracking Error of Simulated US Large Cap Portfolios with Different Diversification Levels

Source: How Diversification Impacts the Reliability of Outcomes, Wei Dei, Ph.D. Dimensional Fund Advisors (November 2016)

 

How do I diversify “Fossil Free”?

 
Until recently, global diversification and sustainable investing were very difficult to do simultaneously. Not anymore. Now you can diversify globally “Fossil Free” or “Low Carbon” — and at low cost.

To explore your options, check out DivestInvest Guide’s Find a Fund Tool and select the “Broadly Diversified” filter to see which sustainable funds leverage broad diversification — Your Buddy in the words of Nobel Prize winner Merton Miller.

  • Some are “Low Carbon” funds available to Do-It-Yourself investors
  • Others are “Ultra Low Carbon”* institutional-grade funds available only through advisors

Advisors can help you identify the mix of investments that best aligns with your risk tolerance and values, and keep you on track through the inevitable ups and downs. Digital advisors automate service delivery via the Internet for your convenience, faster response and, in some cases, offer tools for better financial decision making. Compared to traditional advisors, digital advisors are typically lower cost, and have lower account minimums. (Disclosure: the authors are co-founders of Macroclimate®, a digital advisor going “Fossil Free”.)

* Nearly “Fossil Free” today and transitioning all the way to 0% holdings of fossil fuel reserves and coal-fired power plants in compliance with The DivestInvest Pledge

 


 

Special Offer for Pledge Signatories

Open “Fossil Free” Macroclimate® Account with $10,000

To take advantage of this special low minimum offer, enter “SODI20173” under “Special instructions” when you complete signup. This will allow us to open your account of $10,000 or more. (The standard minimum is $50,000.) Annual fee for a $10K account is only $100. OFFER EXPIRES 12/31/17.

 

 

 


 


Mark R. Kriss
Co-Founder and Managing Partner, Macroclimate®
Chair, Institute on the Environment External Advisory Board

Mark holds a BA from University of California, Berkeley, MA in communication research from University of Minnesota, NASD Series 65 certification, and is a graduate of Stanford’s Executive Program in Financial Management. Mark currently serves as a Chair of the External Advisory Board of the University of Minnesota’s Institute on the Environment, one of the leading climate science research centers, and as a member of the Dimensional Sustainability Funds Council. From 2009 through 2015, Mark also served as Managing Director of Vision Prize®, a research partnership that captures scientific meta-knowledge on climate risks and solutions, in collaboration with IOP Publishing and researchers at Carnegie Mellon University.

 


Peter Kriss, Ph.D.
Co-Founder and Partner, Macroclimate®

Peter received his Ph.D. and M.S. in Behavioral Decision Research from Carnegie Mellon University and B.A. in Mathematics from Swarthmore College. From 2009 through 2015, Peter also served as Director of Research of Vision Prize®.

 

Macroclimate® (macroclimate.com) is an impact investment firm with a digital advisor service for everyday investors anywhere in the US. The firm sustainably manages over $100 million of assets, and has been a Dimensional-approved investment advisor since 2004. As an SEC-registered fiduciary fee-only advisor, Macroclimate® never earns commissions based on where it invests clients’ assets. Macroclimate® is a Certified B Corporation, and donates 1% or more its annual revenue to environmental research and climate action.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

1 The “All stocks” portfolio consists of all eligible stocks in all eligible Developed and Emerging Markets. The portfolio for January to December of year t includes stocks whose free float market capitalization as of December t-1 is greater than $10mln in developed markets and $50mln in emerging markets and with non-missing price returns for December of year t-1. Annual portfolio returns are value-weighted averages of the annual returns on the included securities. The portfolios “Excluding the top 10%” and “Excluding the top 25%” are constructed similarly. Individual security data are obtained from Bloomberg, London Share Price Database, and Centre for Research in Finance. The eligible countries are: Australia, Austria, Belgium, Brazil, Canada, Chile, China, Colombia, Czech Republic, Denmark, Egypt, Finland, France, Germany, Greece, Hong Kong, Hungary, India, Indonesia, Ireland, Israel, Italy, Japan, Republic of Korea, Malaysia, Mexico, Netherlands, New Zealand, Norway, Peru, Philippines, Poland, Portugal, Russia, Singapore, South Africa, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, United Kingdom, and the United States. Diversification does not eliminate the risk of market loss. Past performance is no guarantee of future results.