What do others mean by "Diversification Benefit" or Portfolio Efficiency?

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Random Walker
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What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by Random Walker »

There have been many threads concerning multi factor investing and the potential diversification benefit achieved by adding a certain asset class or style. I'm curious what "diversification benefit" means to others. Is it improved Sharpe ratio, cutting tails, bringing compounded return closer to average return? Are all of those different ways of saying same thing?
Based mainly on reading Gibson's Asset Allocation, to me a more efficient portfolio is one that brings the annualized return closer to the weighted average return of the portfolio components. Volatility is a portfolio killer. To me improved Sharpe ratio, cutting tails, Diversification benefit, improved portfolio efficiency all imply the same thing: bringing the geometric mean closer to the average annual mean by dampening volatility. I'm curious if everyone else views portfolio efficiency and diversification benefit the same way. Thanks,

Dave
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Taylor Larimore
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"Efficient Portfolio"

Post by Taylor Larimore »

Dave:

From the Financial Dictionary:
Efficient Portfolio: A portfolio that provides the greatest expected return for a given level of risk (i.e., standard deviation), or, equivalently, the lowest risk for a given expected return.
Three-Proofs that TSM is Efficient

Best wishes.
Taylor
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Random Walker
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by Random Walker »

Hi Taylor,
Thanks for your response. So you view portfolio efficiency as increased Sharpe ratio. But why is less volatility significant to you? I believe I've even read something by Bogle saying that he didn't really care much about volatility. But as I said above, I believe volatility is a huge drag on returns. In fact I believe an approximation is geo mean = avg annual mean -1/2 SD squared.

Dave
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by Taylor Larimore »

Random Walker wrote:Hi Taylor,
Thanks for your response. So you view portfolio efficiency as increased Sharpe ratio. But why is less volatility significant to you? I believe I've even read something by Bogle saying that he didn't really care much about volatility. But as I said above, I believe volatility is a huge drag on returns. In fact I believe an approximation is geo mean = avg annual mean -1/2 SD squared.
Dave:

I agree with Mr. Bogle:
An extra percentage point of long-term return is priceless, and an extra percentage point of short-term standard deviation is meaningless. -- Jack Bogle
Bogleheads can read more here:

Risk and Risk Control in an Era of Confidence

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle
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Random Walker
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by Random Walker »

That is the exact quote I had in mind :-)

Dave
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by lack_ey »

Depends on context.

Diversification benefit is sometimes meant in terms of reducing idiosyncratic risk of a given security or group of securities. Or perhaps literally in the sense of having a more diverse group of assets with a greater number of units.

But many treat it as a synonym for portfolio efficiency, which is defined more by (perceived) risk/return. I think people who deride "deworsification" think in these terms. It could be that you say you're reducing diversification by concentrating in XYZ in order to boost portfolio efficiency. Some would call that increasing diversification, but others would not.

Risk/return is not all that well defined either. It means different things to cut tail risk, reduce standard deviation, etc. Those are related but not the same, depending on the underlying distribution.
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by tarheel »

Random Walker wrote:There have been many threads concerning multi factor investing and the potential diversification benefit achieved by adding a certain asset class or style. I'm curious what "diversification benefit" means to others. Is it improved Sharpe ratio, cutting tails, bringing compounded return closer to average return? Are all of those different ways of saying same thing?
Based mainly on reading Gibson's Asset Allocation, to me a more efficient portfolio is one that brings the annualized return closer to the weighted average return of the portfolio components. Volatility is a portfolio killer. To me improved Sharpe ratio, cutting tails, Diversification benefit, improved portfolio efficiency all imply the same thing: bringing the geometric mean closer to the average annual mean by dampening volatility. I'm curious if everyone else views portfolio efficiency and diversification benefit the same way. Thanks,

Dave
+1 for bringing compounded return closer to average return. :beer
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by rkhusky »

Standard deviation is a convenient measure of risk, but it doesn't tell the whole story because it doesn't include the time scale. Short term fluctuations, even though they may be large, are not as important as long term fluctuations.
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by dbr »

rkhusky wrote:Standard deviation is a convenient measure of risk, but it doesn't tell the whole story because it doesn't include the time scale. Short term fluctuations, even though they may be large, are not as important as long term fluctuations.
Very true, but long term fluctuations are generated by compounding short term fluctuations.

Put differently, what happens, happens, and you can take the data in any format you want.
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by dbr »

In the Fama-French model some people say a portfolio is more diversified if it has positive loadings on small and value factors. The benefit is higher expected return. I don't think Fama-French has a model for the associated variability of the return. I prefer to say that the expected return is predicted to be higher because a loading on small and value is present. I have no idea what diversification is supposed to mean in such a context.

I am pretty much a purist in that the word is restricted to mean having enough individual investments as to eliminate diversifiable risk. I would also grant adding completely different asset classes, such as bonds to stocks, gold to stocks and bonds, real estate to gold, stocks, and bonds, etc. I would suggest that there is a natural "zero point" for a diversified asset allocation which is the market capitalization. I would call a tilt in the allocation a concentration rather than diversification.

It is also possible to ignore the whole terminology and just detail the construction of the portfolio explicitly and compute the properties thereby generated.
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by rkhusky »

dbr wrote:
rkhusky wrote:Standard deviation is a convenient measure of risk, but it doesn't tell the whole story because it doesn't include the time scale. Short term fluctuations, even though they may be large, are not as important as long term fluctuations.
Very true, but long term fluctuations are generated by compounding short term fluctuations.

Put differently, what happens, happens, and you can take the data in any format you want.
Long term fluctuations are caused by that (small) part of the short term fluctuations that don't average out over longer time periods.
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by stlutz »

I think what we often miss here is that "diversification" and "efficiency" often exist in tension with one another. They aren't the same thing and confusion results when someone advocates a more "efficient" portfolio and calls it more "diversified" (or vice versa). In reality, sometimes a more concentrated portfolio is more efficient.

A couple of examples:

1) Using a total bond index (particularly one that even includes high yield like IUSV does) and including international bonds is the most "diversified" bond portfolio. However, in a balanced stock/bond portfolio, Treasury bonds provide the best counterweight to the equity risk--they have lower correlation to equity returns than pretty much all other bonds. So, *concentrating* one's bond holdings in Treasuries provides more a more efficient portfolio--getting the same return with less portfolio volatility.

2) Smallcap-value stocks are about 3% of the market as typically conceived. Some people here note that SCV has a relatively low correlation to the total market, so a separate position is warranted. This means that one is concentrating their investments in one type of stock--reducing diversification--while improving portfolio efficiency--yielding higher return with less volatility.

Diversification is not focused on returns per-se. It is focused on making sure that one has exposure to many different types of securities. Asking, "Is the total market too concentrated in financials and technology stocks?" is a diversification question. Asking, "Will smallcap value stocks beat the market, improve my returns, and allow me to take less equity risk?" is a portfolio efficiency/returns question.

Both questions need to be asked. And is should be noted that an efficient portfolio is almost always diversified, and a diversified portfolio is almost always efficient. However, the *most* diversified portfolio will not be the most efficient and vice versa. Ultimately one ends up valuing diversification or efficiency more.
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by Random Walker »

Stlutz,
Most people think of diversification in the equity realm as increased number of stocks. Some people believe that since adding another stock to an equity portfolio increases diversification that the natural extension of that is that a TSM equity portfolio is maximally efficient.
But once a person starts thinking in terms of maximizing portfolio efficiency (improve Sharpe ratio), diversifying across sources of return and increasing portfolio efficiency become pretty much synonymous the way I see it. I guess what I'm saying is that if one defines diversification as broadening the sources of potential return for a portfolio, then there is no tension between diversification and portfolio efficiency.

Dave
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by nedsaid »

The old fashioned definition of diversification as not putting all your eggs in one basket sounds pretty good to me. That is not good enough for some people, they want great returns with less volatility, indeed that is the Holy Grail of investing. Being able to draw a straight line with a minimum of squiggles between your starting point and your goal, an annual 7-8% return with a steady ride on the way to the goal.

Investing, just like life, doesn't always work out as planned. All those fancy, schmancy volatile non-correlating asset classes designed for steady returns when combined, will sometimes in a crisis act with great volatility. All that volatile non-correlating stuff decided in 2008-2009 to correlate at the worst time and correlate on the way down! It is like the markets have a sense of humor, showing us smarty pants that we didn't know as much as we thought we did.

Sometimes the best answer to volatility is to just ride it out. Volatility seems to be the price we pay for return no matter what we do to make our portfolio less volatile. If you want less volatility, pretty much it means more bonds which in turn means less return. Hate to break that to you, sports fans, but that has been my experience. Sometimes the tweaks we make to get the diversification benefit or an efficient portfolio works and sometimes they don't.
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by stlutz »

Most people think of diversification in the equity realm as increased number of stocks. Some people believe that since adding another stock to an equity portfolio increases diversification that the natural extension of that is that a TSM equity portfolio is maximally efficient.
But once a person starts thinking in terms of maximizing portfolio efficiency (improve Sharpe ratio), diversifying across sources of return and increasing portfolio efficiency become pretty much synonymous the way I see it. I guess what I'm saying is that if one defines diversification as broadening the sources of potential return for a portfolio, then there is no tension between diversification and portfolio efficiency.
We we redefine "diversification" to mean "portfolio efficiency", we shortcut the thought process of portfolio construction. Looking at both somewhat independently helps us to better understand the advantages and disadvantages of a particular portfolio.

Portfolio efficiency is focused on what you expect to happen. Diversification is focused on what you don't expect to happen.

I don't think it's obvious that a cap-weighted total market index is maximally diversified. If you have 8x the amount of money in technology stocks as you have in materials stocks, is that maximally diversified? On one hand you can say, "yes", as that is reflective of the economy overall. On the other hand you could say "no", as you really want a true balance of different industries in your portfolio. Or, if you had a rule that you want no one stock to be more than 1% of your equities, is that more or less diversified than pure cap weight? Again, a question for legitimate debate. The goal of this exercise is is to limit the impact of idiosyncratic factors on your return--both ones that are known beforehand and not known. Being maximally diversified eliminates the possibility of significantly under or over-performing "the market" (which can be measured in different ways). Diversification is not focused on maximizing return.

When one is thinking about portfolio efficiency, they are focused on getting the maximum expected return for a given level of risk (generally defined as volatility in MPT terms). This is considering the return you expect to get from various assets, the volatility you expect from those assets, and the correlations that you expect from them, and then putting together the best allocation. If you expect to get 8% return from a portfolio with a volatility of 6% and the same 8% return from a different allocation with 12% volatility, you would of course pick the former. Note that this is all based on what you expect to happen and not so much on the unexpected.

To use one of my earlier examples, I have expectations about how Treasury bonds will perform relative to other types of assets. Those expectations lead me to take an overweight position in them relative to other types of bonds because I think they will make my portfolio more efficient. Suppose my expectations don't pan out. Maybe the return spread between corporates and treasuries is less than I expected, or for some reason I didn't expect, corporates have lower equity correlation than Treasuries did. Well, my portfolio in retrospect ends up being less than optimal. That is the risk I'm taking by focusing on efficiency over diversification. Considering "efficiency" and "diversification" separately helps me understand this. If I simply come up with the portfolio I think will do the best for a given amount of risk and calling that the most diversified then I'm being ignorant of the risk I'm taking by concentrating in one type of bond.

A number of threads talk about the "Larry portfolio", composed of Treasury notes (or very similar bonds in terms of credit risk) and smallcap value stocks. The argument is that this portfolio is maximally efficient because a) smallcap value stocks will outperform the market; b) smallcap value stocks are less correlated to T-bonds than are other types of stocks. Because of (a) and (b), you can take less equity risk and still get higher returns. A huge win in terms of efficiency. However, if your expectations about small/value stock and T-bonds don't pan out (and we spend a lot of time debating about how likely these chances are!), then you have a problem. You are very much taking a risk by focusing on one type of bond and on stocks that all share the same characteristics. If you simply say that this is the most efficient portfolio and therefore assume it is the most diversified, you become ignorant of the trade-offs you are taking on by constructing this type of portfolio.

Note that I'm not saying that the "Larry portfolio" is a bad portfolio--it's simply trying to be more efficient at the cost of being less diversified--a perfectly reasonable tradeoff.

In contract to all of this, if I simply invest in something like a Life Strategy portfolio where I hold global stocks and global bonds, I will be very highly diversified. One who makes this choice must understand their their portfolio will never be the most efficient in hindsight (nor will it be the least). If you think that maximizing diversification is the same thing as maximizing your efficiency, you'll probably end up disappointed. When you are the most diversified you'll never be the best. Again, good to understand this up front.
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by larryswedroe »

Stlutz
Just a point on the diversification of the Larry Portfolio.
As you note the answer as to is it diversified depends on your perspective. I would argue it's basically the most diversified portfolio because it has more relatively equal weightings on the factors that have been shown to be the major determinants of risk/return, unlike TSM which owns more stocks (and is more diversified in that way, but has exposure to only beta).

The Larry Portfolio is also highly diversified, just as much as a TSM portfolio, in terms of exposure to systemic economic and geopolitical risks as it's just as globally diversified, and it owns more than enough stocks to minimize the idiosyncratic risks of individual stocks, owning thousands of them.

So IMO it's a matter of perspective.

Best wishes
Larry
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Taylor Larimore
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The "Larry Portfolio?"

Post by Taylor Larimore »

Larry:

What is the "Larry Portfolio?" All I could find is an article in Mint:
Larry Swedroe’s insight was: what if we mix a little of this very risky (but intelligently risky) stock portfolio with a lot of very safe bonds? Say, 30% small value stocks and 70% bonds?

The result is the Larry Portfolio, a portfolio with similar expected return to to 60/40 portfolio I described, but lower risk, because the portfolio is mostly bonds—the kind of bonds that did just fine during the Great Depression and the recent financial crisis.
Is that it? Which funds?

Thank you and best wishes.
Taylor
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Re: The "Larry Portfolio?"

Post by nedsaid »

Taylor Larimore wrote:Larry:

What is the "Larry Portfolio?" All I could find is an article in Mint:
Larry Swedroe’s insight was: what if we mix a little of this very risky (but intelligently risky) stock portfolio with a lot of very safe bonds? Say, 30% small value stocks and 70% bonds?

The result is the Larry Portfolio, a portfolio with similar expected return to to 60/40 portfolio I described, but lower risk, because the portfolio is mostly bonds—the kind of bonds that did just fine during the Great Depression and the recent financial crisis.
Is that it? Which funds?

Thank you and best wishes.
Taylor
Hi Taylor:

The "Larry Portfolio" is 30% small/value funds both US and International. This includes Emerging Markets Small/Value. Don't know what funds he uses but it includes thousands of stocks. The other 70% is in short term treasury bonds.

There are several good articles out there, I am surprised you could only find one. I am sure Larry will respond with more detail.
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The Larry Portfolio?

Post by Taylor Larimore »

Nedsaid:

I was not clear. I found several references to the "Larry Portfolio" by Googling. What I could not find were the specific funds in the "Larry Portfolio."

Hopefully, Larry will see this and give a reply.

Best wishes.
Taylor
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Re: The Larry Portfolio?

Post by oldzey »

A CBS Moneywatch article by Mr. Swedroe from February 5, 2013 describes the process:

How to diversify your investments

Portfolio 6 is what appears to be the "Larry Portfolio".

Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility has a 2014 update of this process.

Best,
oldzey
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by larryswedroe »

the Larry Portfolio uses the highest expected returning asset class, basically small value, to tilt the portfolio to the maximum extent possible, allowing the smallest beta exposure to achieve the financial goal. That can be a very simple two fund portfolio like some of our clients use, Bridgeway Small value and DFA world ex-US targeted value, or three funds like Bridgeway SV and DFA ISV and DFA EMV, or the equivalent in ETFs, or Vanguard funds. The higher the loadings on the size and value factors, the less the equity exposure you need and the lower the tail risks, assuming you use safe bonds.

Reducing the Risk of Black Swans describes the strategy and the logic behind it and presents the evidence.

Now you can add to that with diversifiers as I have done, including Reinsurance and an alternative lending fund (both run by Stone Ridge) and also some AQR funds (style premium and managed futures). But those are not needed in a simple Larry Portfolio as described in the NY TIMES article (you can google it) that give it that name

Hope that helps.
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by Lieutenant.Columbo »

Random Walker wrote:...to me a more efficient portfolio is one that brings the annualized return closer to the weighted average return of the portfolio components...
(how) can a portfolio's annualized return Not be the weighted average return of the portfolio components?
larryswedroe wrote:The Larry Portfolio is also highly diversified, just as much as a TSM portfolio, in terms of exposure to systemic economic and geopolitical risks as it's just as globally diversified, and it owns more than enough stocks to minimize the idiosyncratic risks of individual stocks, owning thousands of them.
Larry,
In your opinion, and experience, is the Larry portfolio only for those who don't have much Need or Willingness to take Risk?

I myself am conflicted about the LP.

I surely would like to be brave enough to implement it, But I feel that I'd be taking larger risk and that with the LP I should expect lower returns compared to my
60% Vang Total US Stock Market
17% Vang Total International Stock
23% CDs+Munis
even though I understand your analysis of the data shows the opposite.

I know. I don't make sense: why be wary of incurring higher risk and exposing myself to lower potential returns with the LP, when it is actually supposed to be the opposite?! :?
Last edited by Lieutenant.Columbo on Mon Nov 28, 2016 9:14 pm, edited 1 time in total.
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by KlangFool »

Folks,

I guess I am diversified over too many factors:

A) 40% in Wellington Fund ( 65/35) -> Active managed

B) 16% Larry portfolio -> 8% Treasury / 8% Small Cap Value

C) 44% Slice and dice passive index fund (Total Market / Total International / Total Bond)

Overall 64/36 portfolio.

KlangFool
30% VWENX | 16% VFWAX/VTIAX | 14.5% VTSAX | 19.5% VBTLX | 10% VSIAX/VTMSX/VSMAX | 10% VSIGX| 30% Wellington 50% 3-funds 20% Mini-Larry
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by KlangFool »

Lieutenant.Columbo wrote: I myself am conflicted about the LP.

I surely would like to be brave enough to implement it, But I feel that I'd be taking larger risk and that with the LP I should expect lower returns compared to my
60% Vang Total US Stock Market
17% Vang Total International Stock
23% CDs+Munis
even though I understand your analysis if the data shows the opposite.
Lieutenant.Columbo,

1) I do not consider Munis as safe.

<<I surely would like to be brave enough to implement it,>>

2) Why do you have to implement 100% LP? In my case, as I glide towards increasing my fixed income ratio, I increase my Small Cap Value portion. I am 16% LP.

KlangFool
30% VWENX | 16% VFWAX/VTIAX | 14.5% VTSAX | 19.5% VBTLX | 10% VSIAX/VTMSX/VSMAX | 10% VSIGX| 30% Wellington 50% 3-funds 20% Mini-Larry
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by larryswedroe »

Lieutenant
First, we have many people with Larry Portfolios with 100% equities, so it can be for anyone. Remember there are two ways to use the ex-ante premiums. The first is to provide higher expected returns, accepting both the tracking error and greater economic cycle risks, and the second is the version I use as described in Reducing the Risk of Black Swans, to cut tail risks (both good and bad).

And if you buy the kind of munis I recommend, only AAA/AA and only GO an essential service revenue bonds, and intermediate term,IMO you can regard them as highly safe, though clearly not as safe as Treasuries. Even in the Great Depression these type of bonds had default losses in low single digit percentage points.

And of course it's possible to underperform using the strategy. But investing is about putting the odds in your favor as there are no sure things. The tables in my new book demonstrate that you do put the odds in your favor by diversifying across the factors.
Now the LP might underperform, but it will almost certainly also cut the tail risks, so it can accomplish the main goal for those desiring that outcome. Even though it underperformed in last few years for example, it still cut the tail risks and allowed investors to sleep well, just as it did in bear markets of 2000-02 and again in 08-09. It's hard to do worse when you cut beta exposure so much, which is what the LP allows one to do.

And finally, don't have to make it black or white, can tilt some without tilting all the way to the LP. Maybe 10% of our clients use the LP, with most having more like 0.3 loadings on size and value.

Hope that is helpful
Larry


Klang
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by Lieutenant.Columbo »

larryswedroe wrote:Lieutenant
First, we have many people with Larry Portfolios with 100% equities, so it can be for anyone. Remember there are two ways to use the ex-ante premiums. The first is to provide higher expected returns, accepting both the tracking error and greater economic cycle risks, and the second is the version I use as described in Reducing the Risk of Black Swans, to cut tail risks (both good and bad).

And if you buy the kind of munis I recommend, only AAA/AA and only GO an essential service revenue bonds, and intermediate term,IMO you can regard them as highly safe, though clearly not as safe as Treasuries. Even in the Great Depression these type of bonds had default losses in low single digit percentage points.

And of course it's possible to underperform using the strategy. But investing is about putting the odds in your favor as there are no sure things. The tables in my new book demonstrate that you do put the odds in your favor by diversifying across the factors.
Now the LP might underperform, but it will almost certainly also cut the tail risks, so it can accomplish the main goal for those desiring that outcome. Even though it underperformed in last few years for example, it still cut the tail risks and allowed investors to sleep well, just as it did in bear markets of 2000-02 and again in 08-09. It's hard to do worse when you cut beta exposure so much, which is what the LP allows one to do.

And finally, don't have to make it black or white, can tilt some without tilting all the way to the LP. Maybe 10% of our clients use the LP, with most having more like 0.3 loadings on size and value.

Hope that is helpful
Larry...
Larry,
Thank you very much for elaborating on the LP.
To learn more about this, if you had to pick one book Today, would you read the Black Swan book or your most recent one?
Thanks.
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Random Walker
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by Random Walker »

Lieutenant,
The geometric return of portfolio is always less than the average annual return of the components because volatility is a huge drag on portfolio returns. Take the simplest and most extreme example. A portfolio goes up 100% in first year and declines 50% in next year. It's average annual return is 25%. Your portfolio though is right back where it started. With $100, the average annual return is 25%, the compounded return is 0%.
This is why it is so valuable to diversify across non correlated sources of return.
Dave
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Re: What do others mean by "Diversification Benefit" or Portfolio Efficiency?

Post by Random Walker »

Lieutenant,
FWIW, I'd start with Black Swan to get the general concept. Whether the investor is 100% equities or 10% equities, the point is to diversify the equity risks away from market beta alone with big doses of uncorrelated and higher expected returns small and value.

Dave
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