Part 2

“Don’t put all your eggs in one basket.” The origin of this phrase is unclear. Some have attributed it to Miguel Cervantes, who penned the classic book “Don Quixote.” “It is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket,” Cervantes writes. Regardless of the origin, the lesson is that if one metaphorically collects eggs in one basket rather than separating them into a number of baskets, one risks suffering a more severe financial loss. By placing a few eggs in each of multiple baskets, one can mitigate the risk of unforeseen mishaps.

This principal is often used as a metaphor for the basic ingredient to successful risk mitigation in an investment portfolio. In portfolio management parlance, this is referred to as diversification. In this final article of the series, I hope to convey certain important aspects of a successful diversification strategy. Failing to recognize the many, and sometimes subtle, nuances of successful diversification can result in unfavorable outcomes. This is especially true when financial markets are in flux.

The most basic element in formulating a diversification strategy is investing in disparate asset classes. On a basic level, most advisors recommend an approach that strategically divides a portfolio among equities (stocks), fixed income (bonds) and money market funds (cash). While there are no one-size-fits-all rules for establishing an individual’s optimal asset allocation, there are some useful rules of thumb. As I pointed out in last week’s piece, in general, a young investor with a long investment time horizon should have a relatively healthy allocation to equities and a smaller allocation to bonds and cash. Many retirees, particularly those who draw income from their portfolio, typically should have the lion’s share of their portfolio invested in fixed income securities.

Of course, there are many other asset classes such as real estate, collectibles, annuities, private equity, commodities etc. When reviewing one’s asset allocation, one should consider all one’s holdings and determine the weighting of each asset class within the portfolio, as well as its attendant risks. But for the sake of simplicity, I will focus on the equity and fixed income portions of the portfolio.

Now, let us say that an investor has determined an appropriate allocation to stocks, bonds and cash. Within those asset classes, there are a number of potential “stealth” risks that can cause risk mitigation strategies to falter, particularly during volatile markets. Within the fixed income portion of the portfolio, if there is a large exposure to riskier bonds, the bond allocation will have a diminished buffering effect on the overall portfolio. High-yield bond mutual funds suffered losses similar to equity mutual funds during the downturn. While many of those funds have recovered substantially from the lows in March, high-yield bond funds remain down on the year. Conversely, funds with the highest-quality bonds performed significantly better and were more effective in portfolio risk mitigation.

Another aspect of diversification in a bond portfolio is related to the average duration of the portfolio, or its sensitivity to interest rate fluctuations. Historically, the best-performing bonds during periods of financial instability are long duration U.S. Treasury securities. Many long-term Treasury bond funds were phenomenal performers during the market meltdown. Moreover, many of those funds continue to register strong positive year-to-date returns, even after the equity market recovery. (One note of caution: Long duration bonds typically underperform during periods of rising interest rates.)

There are other more subtle nuances to address when constructing a durable bond portfolio. I believe that having an appropriate percentage allocation to bonds is a necessary, but not sufficient, condition to help weather periods of market dislocation.

When analyzing the equity side of one’s portfolio, there are several potential hazards that require understanding. The most basic element to constructing an equity portfolio is limiting the exposure to any individual stock. For example, many advisors follow a disciplined strategy of not investing more than 3-5% of the portfolio in any one stock. Even if an investor has an elevated appetite for risk, one should establish limits and monitor the percentage allocation to any single stock. Some of the largest and “bluest of blue chip” companies have experienced unanticipated declines in their businesses and share prices. Since the turn of the century, some of the largest companies by market capitalization have not yet recovered the losses in share price from their all-time highs. General Electric, Cisco Systems and Exxon Mobil, three of the four largest companies by market capitalization at the end of 1999, fall into that category. In the most extreme case, General Electric’s stock has declined a whopping 85%.

Beyond individual stock risk, there is a deeper level of risk in an equity portfolio—sector risk. Some might view their portfolio diversification solely through the lens of exposure to any one company. But one must also monitor sector exposure. One stark example is the airline sector, which was flying high in early 2020. The sector now faces an existential threat as a result of the COVID-19 pandemic. If one had a heavy exposure to the sector, the fact that one may have owned a variety of shares within the sector would have been of little help in mitigating the overall sector risk. To be sure, there is always a diversification benefit to investing in different companies within a sector. Nevertheless, overexposure to any one sector in the market clearly presents risks to the overall portfolio.

Now let us look at equity diversification on an even deeper level. Even if a portfolio is effectively diversified on a sectoral basis, the pandemic has shown that disparate sectors can have common risk factors to exogenous events. Going into this year, a seemingly diversified equity portfolio may have suffered poor performance if the portfolio had overexposure to broader themes such as travel and leisure. A large allocation to stocks in a number of sectors such as airlines, car rental companies, cruise ship operators, entertainment companies, restaurants, mall retailers, movie theaters, hoteliers, casino operators etc. would have been overexposed to the adverse effects of mandated shelter-in-place orders.

Now one may argue that this observation amounts to “Monday morning quarterbacking.” That may be true, but I would argue that the lesson from the COVID-19 pandemic is that investors need to be more alert to a wider variety of potential risks as the crisis unfolds.

The pandemic aside, there are other, more typical, market risk factors that surface through the business cycle and require investor attention. Some well-known risk factors include exposure to interest rates and inflation. When analyzing one’s portfolio, one should question overall portfolio exposure to their holdings that could be negatively impacted by an increase in interest rates. For example, homebuilding stocks, utilities and real estate investment trusts (REITS) tend to perform better when interest rates are falling rather than rising. From the inflation angle, one needs to assess the balance between stocks that benefit from a general rise in commodity prices versus stocks of companies that will likely face margin pressure as a result of higher input costs.

I would like to wrap up this series by highlighting that successful investing requires thoughtful analysis and a disciplined playbook. With the proper understanding of the many risk factors, some investors may find success flying solo. For those investors who do not have the time, expertise, desire or intestinal fortitude to effectively manage their portfolios, they should consider consulting with an investment advisor. No matter the path one chooses, one should understand that while investing has its risks, there is also a path forward to investment success.

Cervantes’ book “Don Quixote” was made into the Broadway hit “Man of La Mancha.” The theme song was “The Impossible Dream,” which is a clarion call that beckons us all to pursue a life full of purpose and great achievement. Successful investing is not only a possible dream. With the proper discipline and effort, one can indeed reach one’s own “unreachable star.”

Jonathan D. Caplan, a former Wall Street executive, is president and founder of wealth management firm Caplan Capital Management, Inc., with offices in Highland Park and Hackensack. He holds a BA from Yeshiva University and an MBA in Finance from New York University Stern School of Business. You can find other recent investment articles by Jonathan at www.caplancapital.com/blog.

The views presented are those of the authors and should not be construed as personal investment advice or a solicitation to purchase or sell securities referenced in this market commentary. The authors or clients may own stock or sectors discussed. All economic and performance information is historical and not indicative of future results. Any investment involves risk. You should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice. All information is obtained from sources believed to be reliable. However, we do not guarantee the accuracy, adequacy or completeness of any information and are not responsible for any errors or omissions or from the results obtained from the use of such information.