Intelligent Design

John McMillen | Portfolio Manager

Learn what matters - and what doesn't - when building a sound investment strategy.

A Clear Lesson On The Virtues of Effective Diversification

September 2008

The recent market turmoil has shown that diversification is more important today than ever before. With the implosion of some of Wall Street’s oldest and largest companies, many of whom have survived numerous crises before, the hard lesson is that no individual stock today is immune to a sudden collapse.

Obviously the collapse of two major Wall Street firms and the wipeout of shareholder value in AIG, Freddie Mac and Fannie Mae was an unforeseen occurrence. However, the investment strategy we employ at Capital Directions -- Modern Portfolio Theory -- is specifically designed to minimize the impact of any one stock on the portfolio, and while our portfolios had exposure to many of the stocks that have been affected in the market turmoil, their overall impact has been negligible.

The table below illustrates this; it shows the return of nine of the most well-known financial stocks that have been most affected by this crisis, their year-to-date returns and their allocation in our most aggressive and least aggressive portfolios almost 4 months before the crisis began.

 
 
May 31, 2008
Stock
YTD Return
Most Aggressive
Most Conservative
American International Group   (AIG)
-95.29%
0.28%
0.002%
Bear Stearns Cos.   (BSC)
-100.00%
0.01%
0.002%
Fannie Mae   (FNM)
-98.74%
0.03%
0.007%
Freddie Mac   (FRE)
-99.01%
0.00%
0.000%
JP Morgan Chase & Co.   (JPM)
-5.05%
0.67%
0.168%
Lehman Brothers Holdings, Inc.   (LEH)
-100.00%
0.01%
0.004%
Morgan Stanley    (MS)
-56.71%
0.14%
0.035%
Merrill Lynch    (MER)
-57.41%
0.12%
0.031%
Wachovia Bank    (WB)
-60.41%
0.00%
0.000%
Total
 
1.264%
0.248%

The table shows that, while our portfolios had exposure to these securities, our exposure was by any measure minimal. Clearly, having exposure to thousands of different securities all over the world virtually assures that our investors will never see their net worth vanish due to the fate of a single company or sector.

In contrast, investors in the very popular Legg Mason Value Trust and Dodge & Cox Stock Fund were not so fortunate. Their managers took on far more risk for their investors by loading up on many of the stocks that ultimately imploded or were under such distress, they were almost certainly heading in that direction.

Stock
Legg Mason Value Trust
Dodge & Cox Stock Fund
American International Group (AIG)
2.66%
2.56%
Bear Stearns Cos. (BSC)
0.00%
0.00%
Fannie Mae (FNM)
0.00%
1.47%
Freddie Mac (FRE)
3.02%
0.00%
JP Morgan Chase & Co. (JPM)
4.20%
0.00%
Lehman Brothers Holdings, Inc. (LEH)
0.00%
0.00%
Morgan Stanley (MS)
0.00%
0.00%
Merrill Lynch (MER)
2.08%
0.00%
Wachovia Bank (WB)
0.00%
3.17%
Total
11.96%
7.20%

For the year-to-date, those funds have posted returns of -35.21% and -22.09% respectively. Bill Miller, manager of the Legg Mason Value Trust fund, now trails the S&P 500 by almost 1% annually for the past 10 years. A simple buy-and-hold strategy in an S&P index fund would have beaten one of the most respected value investors of all time.

The recent financial crisis has really shown investors two things: First, no matter how much faith you have in your (or your manager’s) stock-picking ability, sometimes you can be wrong – horribly wrong. In fact, Bill Miller and his army of MBAs and PhDs had so much confidence that Freddie Mac was the solution, and not part of the problem, they were aggressively adding to an already staggering 53 million-share position as early as July of this year. As they say, “If he liked it at 35 he must have loved it at 10”! Though this is just one data point among many, it demonstrates the fallacy that active managers can help protect against losses in down markets.

Second, and more importantly, though the tech crash in 2000 showed worthless companies can become, well, worthless, this crash showed even companies with considerable value can quickly become worthless under the wrong circumstances, which only serves to reinforce that effective diversification is more important than ever.

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