In the age of indices, risk management diversification has become opaque – Marin Independent Journal


Investing is both an art and a science. We use scientific tools to measure return probabilities, analyze financial statements for trends and track economic models.

But like artists, success depends on creative thinking about psychology, differentiating styles, and taking risks that science can’t explain. These facets of investing lead to a wide range of philosophies and only a few industry-agreed methods.

Politics, natural disasters and viruses have proven many theories flawed. However, some sayings from icons like Benjamin Graham and Warren Buffet endure. One that rings true today is the timeless saying, “don’t put all your eggs in one basket”.

Professional investors agree that diversification is one of the keys to success, although the degree of diversification is debated – Graham proved that a portfolio of 15-30 stocks was needed to achieve maximum diversification benefits there. nearly a century old. Curiously, active investors often compare their returns to S&P 500 stocks.

You could say it’s too diverse, but even more curiously, the indices are concentrated in a few powerful tech companies. It’s hard to understand why we would compare these two types of portfolios: one where each slice represents about 3% of the cake, versus the other where some slices represent 7% and other slices 0.01%. The contrast between these two styles is clear.

The scope of the market is under scrutiny and antitrust debates surround big tech companies. But what does all this mean for individuals?

Diversification, the only universal risk management tool in our industry, has now become opaque. Apple, Google, Facebook, Amazon and Tesla make up 16% of the MSCI World Index. Twenty-four percent of the S&P 500 is made up of these names. Given these large weightings, the correlation between the stocks of these companies and the overall performance of the index is surprisingly high.

This correlation has benefited investors as stocks have performed well and companies have prospered. Many of them have ample liquidity and high quality profits. They accurately represent the largest sector of the US economy and the company has proven, thus far, that very little will inhibit demand for the products and services of these companies.

But will professional investors allow this trend towards concentration to continue and allow themselves to be lulled into forgetting that diversification is the only rule we can agree on? Let’s hope not, because the contribution of these stocks to the return of the S&P 500 can also be very negative.

Many blame the proliferation of passive investing, the explosion of mutual funds, and the booming business of exchange-traded funds (ETFs) for the current situation. Indeed, every two weeks when the bulk of Americans receive a paycheck, a significant percentage is passively invested in index products, funneling the most funds to the largest holdings and reinforcing a cycle.

Even professional investors have a positive bias towards these faithfully performing companies. The current concentration of technology companies is the deepest in history, but with the belief that markets are not perfectly efficient and a world obsessed with data, we believe that active investors can still profoundly influence markets.

The speed at which things are changing historically is reassuring. Thirteen years ago, the largest companies in the S&P 500 included Exxon, Citigroup, AT&T and Walmart. These companies have been deeply affected by the changes of the last decade.

We have seen the energy goliaths dethroned, the financial system restructured with the Dodd-Frank Act and other post-financial crisis regulations, smart phones proliferated as a way of life and a business necessity, and small businesses empowered in line. So when we look at today’s themes, we wonder if the current kings of the S&P 500 will continue to reign in 2035. Will growing consumer privacy concerns change that? How about working remotely? What about global warming or the impending threat from China?

The historic priority of change makes us grateful to be active, individual investors in equities. Index strategies could face significant pressure in the coming years, especially as we are at the most consolidated point in history.

The illusions of diversification in today’s indices are real, and investors would do well to remember the idea we all agreed on, “don’t put all your eggs in one basket”.

Lily Taft of Mill Valley is a portfolio manager at Main Street Research. Info and Disclaimers:


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