William Bernstein on Diversification

“The good news is that in reality, risk and diversification are about what happens over the long haul, not during a punishing downturn like 2007-2009.” – William Bernstein

In Skating Where the Puck Was, William Bernstein tackles one of the central tenets of any comprehensive investment plan — diversification.

Specifically, Bernstein discusses correlation among the different asset classes.

The reason investors practice diversification is to stay away from the proverbial ‘putting your eggs in one basket.’ Spreading your portfolio among different asset classes, geographies, markets and companies gives you a higher probability of averting disaster by making a bad decision on any particular investment.

You give up the opportunity to hit home runs for the safety of not striking out. Singles, double or even getting on base is the idea when it comes to patient wealth creation.

In an ideal world, you’d like to pick asset classes that offset each other or have negative or no correlation with each other. You want some investments to zig when others zag for a balanced approach.

This is a difficult proposition because it requires a contrarian attitude as well as a value investing tilt that can be difficult for most investors to implement because of emotional factors. Here’s Berstein’s take:

“Diversifying is easy; doing so early is difficult.”

The problem Bernstein finds in this book is that once low correlation diversification becomes well known or easily investable, those correlation advantages tend to disappear. Here’s his take:

“Early adopters reap the initial high returns and low correlations of a novel asset class; then one or more multiple academic and trade journal articles will describe those benefits, always accompanied by plump, curvaceous two-dimensional mean-variance plots. Last come Readers Digest versions in the mass media.”

Bernstein proves his point on this through the example of commodities investments. Before the 1990s, it was nearly impossible to invest in physical commodities without a seat on the futures exchange a la Trading Spaces.

Fast forward a couple of decades and now Wall Street has all kinds of products aimed at investors that involve commodities. This development has led the correlation benefits to decrease dramatically in that time.

The other problem with diversification is that is can fail you at the worst possible times. We saw this in the 2008 crash when everything got killed, save for cash and U.S. Treasury bonds.

Bernstein has an answer to this conundrum:

“In short, resign yourself to the fact that diversifying yourself among risky assets provide scant shelter from bad days or bad years, but that it does help protect against bad decades and generations, which can be far more destructive to wealth.”

When markets go terribly wrong, correlations tend to go to 1 (everything falls together). But you shouldn’t be worrying about how one crash will affect your portfolio if you have the correct perspective on your time horizon and asset allocation.

Bernstein goes further on this topic:

“Your long term results are less the result of how well you pick assets than how well you stay the course during bad periods, particularly if they occurred late in your investing career.

Many investors completely changed their risk tolerance and behavior during the financial crisis. This led them to sell near the bottom and put all of their investments in cash or bonds causing them to miss the inevitable recovery in stocks.

Risk tolerance is something that should be determined based on a wide range of factors, but it shouldn’t change on the fly during market extremes. Your risk tolerance should remain the same regardless of the level of the markets, even if your nerve or overconfidence doesn’t.

Keeping a level head about the markets and resisting the urge to use recent events when making long-term investment decisions is extremely difficult. Hence, the fact the investing isn’t complicated, but it is tough to put into practice.

Here’s Bernstein on keeping a long-term frame of mind:

“Building a widely diversified portfolio is surprisingly simple. Alas, maintaining it properly involves an appreciation of both the valuations of its individual asset class components and the character and discipline of its owners, something that the nation’s largest institutional investors and their clients may not be doing particularly well.”

It’s not only individual investors that have trouble keeping the correct long-term perspective on the markets. Wall Street and large institutional investors also have a hard time keeping their emotions in check (and they are pressured by the culture to be short sighted at times…individuals don’t face this same burden).

The long view requires not only investment discipline, but also spending discipline as well:

“Long-term thinking, unfortunately, may be more a matter of character than training; the parent who buys a Beemer and a 5,000 square foot house before he’s secured his retirement and his kids’ future college expenses may have already lost that particular game.” 

I have no problem with people spending money and enjoying the fruits of their labor. It’s not worth it to save everything you make and not enjoy your life now. You can’t focus 100% on your future self.

Just make sure you make you saving aggressively and automatically so you can spend the rest without feeling guilty.

Skating Where the Puck Was: The Correlation Game in a Flat World

Further Reading:
Lessons From William Bernstein



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  1. JC @ Passive-Income-Pursuit commented on Jan 18

    Coming up with a plan and sticking with it through thick and thin will do wonders for the average investor. I’m not sure if this is common across most 401k plans, but mine has an auto-rebalance that you can schedule for quarterly, semi-annually, or annually. If most investors just took the time to come up with a reasonable allocation plan and used the cheapest funds to invest and utilized the auto-rebalance feature they’d be a lot further ahead. There’s a lot of stories of people cashing out of stocks right when they should be plowing every cent they can into them. That just sets them up to lag the markets when they take off and leads to the idea that investing is a casino. If only there was a way to have investors only get to see the total balance but not the performance of each fund they own. They’d be better in the long run. Although blocking their balance would probably be even better.

    • Ben commented on Jan 19

      Most of the 401k plans I’ve seen have that feature. Same thing with any fund company. It’s a great feature that simplifies things immensely.

      I really like your idea of seeing the balances but not the performance. The total balance is the end goal anyways. Takes away the performance chasing game that people fall into.