Diversification

There seem to be MANY views on the subject of diversification. Some commentators recommend it wholeheartedly, while others think of it as a crutch for imperfect or insufficient processes.

But that's not quite what we're going to think about today.

I was doing a bit of reading over at the Hedge Fund Blog and it occurred to me that the author, Mr. Allen, is recommending a diversified strategy. Could this really be the case - a hedgie recommending portfolio diversification? (Who knew?) I'm no expert on MPT but it appears to be the cornerstone of a good number of hedge fund managers and professional investors in many different asset classes. So maybe there is a place for diversification in alpha generating strategies, no matter the opinions of Robert Kiyosaki or Warren Buffett.

Mr. Allen appears to advocate plenty of portfolio diversification - lots of different hedge fund strategies. Now, while his bias is apparent, he may be on to something for even us smaller investors. So how about combining this idea of "portable alpha" (can I say that?) and diversification a bit more? "Alpha-centric investing" would seem to automatically require some level of diversification among asset classes, asset weightings, strategies, and managers anyway. It becomes a portfolio construction exercise, then, to put all the pieces together on an individualized basis.

Moving this concept downstream, the question becomes how do you effectively integrate diversification into a personal portfolio, with an emphasis on alpha generation? Can it even be done simply, or do we really need to rely on the mathematical models, MPT and various other complex tools of the professionals?

For example, I have come up with the following asset allocation based on my own (subjective, non-quantitative) risk profile:

20% US Small Cap Equity
16% International Mid Cap Equity
12.5% US Large Cap Equity
10% International Small Cap Equity
8 % US Fixed Income (FI)
6.75% Emerging Market (Mkt) Equity
6.25% International and Emerging Mkt FI
6% International Large Cap Equity
5 % US TIPS
4% US Real Estate
3.5% Commodities
2% Cash

Not all of those slots are filled out, which means I'm overweight in some areas and underweight in others. I'm still adjusting the allocations and seeking out ideal investments for certain categories, commodities in particular. (Keep in mind that this only includes securities and other vehicles which trade on markets. None of my personal RE holdings will be included, nor are those made with my partners.) I think this covers a fair amount of the investing landscape. It may cover too much and I am considering ratcheting down some of these allocations. I think I would prefer to stay close to fully invested but I'm not married to the idea. I'm completely open to higher concentrations in certain areas.

Anyway, I can see how diversification can be considered a crutch for not enough information. However, for those who don't have the resources to acquire and analyze all of that information, it makes perfect sense. More importantly, good diversification can work as a hedge (there's that word again) against miscalculations, bad timing and other problems. Not a perfect hedge, of course, but any downside protection you can muster is a good thing - if it protects, that is.

Soon, I'll look at doing some ad-hoc portfolio de-/re-construction, including some ideas on how to add a bit of extra return with (hopefully) little added risk.

Until next time...