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Tuesday August 7, 2007

Release Date: 08.07.07 | Location: All Metro Atlanta | Organization: Minerva Planning Group

Daybook Expert Spotlight: Micah Porter of Minerva Planning Group

What is and isn't "diversification"?

Our newest Daybook Expert, Micah Porter, CFA, President and CEO, Minerva Planning Group, joins us with his expertise in wealth management. Minerva Planning Group is a fee-only wealth management firm with locations in Atlanta, Alpharetta, and Saint Simons Island. For more information, the website is http://www.minervaplanninggroup.com

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Volatility has returned to the market, but most experts will tell you that market timing just isn't a viable investment strategy. So what is a long-term investor to do in times like these? We believe the first line of defense is having a diversified portfolio. But what exactly does that mean?

What Diversification Is and Isn't
A diversified portfolio in our view is a portfolio consisting of investments in different asset classes. Asset classes are groupings of investments that share characteristics - stocks of small U.S. based companies are a good example of an asset class, as are bonds issued by U.S. companies, or even stocks of companies in emerging markets such as India or Turkey. The companies issuing the securities aren't grouped by what they do, but are instead grouped by the size of the company, and can be further subdivided by other valuation metrics such as the ratio of price of the stock to company earnings, or price of the stock to book value of the company.

One thing that should be emphasized here does not qualify as a diversified portfolio according to our definition. A diversified portfolio is not a portfolio that consists of investments in different industries or a portfolio that consists of stocks of a number of different companies. While such portfolios might be considered diversified - if the stocks also happen to come from different asset classes as we've defined them above - such portfolios are not necessarily diversified. So why does this matter?

How Diversification Works
The reason it matters is that analyses of market data over the course of decades reveals that the price of different asset classes - again as defined above - don't necessarily move in lock-step. A good example can be found in comparing the U.S. fixed income market with large cap U.S. stocks. When the S&P 500 moves downward sharply, investors often take refuge in bonds (i.e. fixed income) thus driving up the price of bonds as the price of large cap stocks is decreasing. Further, even within the stock market, while stocks may move in the same direction, the rate of change might differ. For example, small cap U.S. stocks have outperformed large cap U.S. stocks for the last several years, but earlier this year large caps began to close this gap.

The difference in price movements among asset classes is the basis for portfolio diversification. By creating a portfolio that is diversified among asset classes, the idea is that an investor can target a specific long-term level of return over the long-term with less fluctuation in total portfolio value along the way. Furthermore, even if the long-term return is the same as might be found in a non-diversified portfolio, mathematical analysis shows that lower fluctuation leads to a higher probability that the investor will achieve his or her goals. Just as importantly, lower fluctuation in portfolio value means lower investor stress, and it's difficult to put a value on that.