Diversification Is More Important Than Style

A long-standing argument in the investment community has been whether active management of a portfolio can actually produce better investment results than a passive portfolio. And with the volatility of the markets in recent history, this conversation seems to have moved to the forefront.

An actively managed portfolio uses the skill of a single, or team of managers that use technical analysis, research and their personal judgment to determine which investments (we’ll use stocks for this example) to buy and hold, or sell within a portfolio. The manager(s) typically operate within a specific discipline, i.e. large cap growth, small cap value, international, etc. Those who subscribe to this method of money management do not buy into the efficiency of markets. They believe there is enough inefficiency and imperfect information that it is possible to profit from identifying mispriced (either too high or too low) securities.

Passive investing can also be described as “indexing”. Subscribers to this approach of investing believe that markets are efficient and that all information that is available on a specific stock is known and built into the price of the security. These folks believe that in the long run, parking money in an index, such as the S&P 500, would yield better investment results than actively trading and picking specific stocks within the index. The argument becomes more compelling when you consider management fees and trading costs in the actively managed portfolio that can drag down performance.

And of course, it is also possible to be an active trader of passive investments, such as exchange traded funds, or ETF’s, which have become wildly popular with good reason. This investment is low cost, liquid, and is easily traded like a stock. An ETF can be tied to one asset, i.e. gold, or a group of assets, like dividend paying stocks.

What is sometimes missing in this conversation is the notion that according to the widely accepted 1986 study by Brinson, Singer,and Beebower, asset allocation of a portfolio accounts for 91% of the long term performance of a portfolio. Market timing and stock selection are considered to have far less impact. So even if you choose the passive route, it is unwise to think you can put all your eggs in one basket, or one index, like the S&P 500 and think you will have long term success.

Diversification, which is choosing the right mix of asset classes, whether it be large companies, medium companies, or small, domestic or international, developed or emerging markets, traditional asset classes or alternatives, just to name a few – is a far more important decision than whether to hire money managers, use indices, or a combination of both. And with all the available investment products and solutions, even self-proclaimed passive investors need professional advice to get it right. And don’t forget that the “right” portfolio, or asset mix, is never “one size fits all”. It is what is right for you at this moment- and can change as your life circumstances change.