Diversifying Diversification in Investing

Who hasn't heard the diversification mantra countless times from financial advisors to mitigate great swath of risks? Even if you grew up with your elders telling you not to put all your eggs in one basket, continue reading on dear reader. Yes yes it's good to diversify but it's not prescriptive on it's own.  What are the categories and how much of each?  Also the 2008 crisis showed us that stock/bond diversification gave you a false sense of safety as almost all market assets declined severely albeit some less than others.   Diversification itself has many faces and all is not as straight forward as it seems.  The below is not financial advice but an exploration of the different ways I looked into diversifying or intensifying beyond the usual asset classes. As the post is long, I've summarized the different factors of diversification below and some of the topics were so unwieldy as to merit their own posts.

• time - DCA vs lump sum investing
• risks - choosing among the most palatable dangers
• asset classes - equities, bonds, cash equivalents, real estate, commodities
• investment vehicles - preferreds, ETFs vs CEFs vs Mutual Funds, derivatives
• investment strategies - passive vs active vs smart beta, income vs growth vs value vs DGI
• sectors
• capitalizations
• geographies
• tax handling
• financial information diet- traditional vs crowdsourced 

Time Diversification

Time is the most essential ingredient in investing, something late starters like myself come to realize keenly.  Not only the time to dollar cost average into positions but time to rise or recover from losses.  I cover the vagaries of not having time in this separate post.

Risk Diversification

I heard on a podcast that risk cannot be destroyed, only be transmuted.  When I first moved out to the Bay Area, all my East Coast peoples would say to me- "I could never live in California. Earthquakes you know".   They probably saw the same ABC drama about a guy who got his legs cut off on the Bay Bridge on the lower deck during the '89 Loma Prieta Earthquake. I have to admit I sometimes would think of that scene when returning home to the East Bay from San Francisco. But the East Coast is rife with regular weather risks- hurricanes, extreme heat, snow storms.

As seen in my exploration of risks, there are a great many sure things coming our way- some unavoidably cyclical risks such as recession and end of a credit cycle and others secular like unfavorable shrinking demographics.  You can't have zero risk, just pick the most palatable ones you can live with. Being in cash just exposes you to devaluation/inflation risk.  I want to be exposed to different types of risks(interest rate risks/market risks) and reduce the scariest risks such as corporate credit bubble.  I also thought it prudent at this this year to lower beta risk and growth stocks.

Asset Class & Investment Vehicle Diversification

2008 showed us that traditional asset class diversification did not protect you entirely from heavy losses as stocks, bonds, real estate all crashed simultaneously and spectacularly.  Non mortgage bonds did drop ~20%(which counts as a large loss in my book) but a drop far less than 50% drop of equities. One asset vehicle I haven't used until this year is preferred stocks which provides higher dividends at a more stable price. As mentioned in my risks article, I don't use volatility or traditional measures of risk to allocate stocks vs bonds.

Asset Classes:
Financial literature claims asset allocation determines majority of returns.  This makes life easier as one does not have to agonize over stock picking. Of course the pain is determining to what ratio one holds these asset classes as appropriate to one's life situation. There has been talk of the death of the 60/40 balanced portfolio in this low interest environment. 

• equities - Growth stocks have dominated the market in the last decades and the conventional wisdom is that to really grow your money you have to invest in the equity market.
• I hold equities that are bond proxies like utilities or preferreds.
• fixed income/bonds - Fixed income markets are more diverse, complex and larger than the equities market. I've shifted overweight to fixed income early this year as explained in this post.
• cash equivalents
• real estate/REITs - I've increased allocation to 15% as REITs are a steady income producer
• commodities- this is the first time in my life I've added commodities as 3% allocation after reading and listening to Ray Dalio's arguments for holding this asset class. 
• gold & silver - This is the first time in my life I started a tiny position in gold and silver.
• cryptocurrency - I diverted my boba and lotto ticket money here.

Investment Vehicles/Instruments:
An investment vehicle is the concrete financial product type that holds assets in one asset class or span multiple asset classes.  Except for preferred stocks, I don't choose the investment first based on vehicle type since returns tend to be largely driven by the underlying asset class.  Instead asset class/sector selection comes first and then figuring out the best ways to gain exposure.  

• stocks - currently I don't hold individual companies and opt for passive and active funds as I don't want to deal with the idiosyncratic risk.
• preferred stocks - a good income producing vehicle that bridge bonds and equities.  I hold individual preferred shares as well as general and sector preferred funds for diversity.
• ETFs - passive index ETFs is the mindless way I pump money into equities.
• mutual funds - currently avoiding due to lack of liquidity and higher fees compared to ETFs
• CEFs/close end funds - currently the main income generators of my portfolio
• derivatives 
• currently I don't use them directly though I hold some funds that generate income with a covered call options strategy

For instance for my REIT exposure, I use a spectrum of vehicles mostly to learn about the sector. 

• ETF- VNQ, the default Vanguard option
• CEFs - RQI, JRI
• individual REIT preferred shares
• REIT preferred CEF fund - RNP
• individual stocks for mREITs

Could I have gotten away with just one ETF? Sure, I only had VNQ for a number of years which is a common and simplest way a lot of investors gain exposure to REITs.  I am trying a number of vehicles mostly to learn about the sector and CEFs due to their leverage have incredibly juicy yields. 

Asset Management Strategy Diversification

Active vs Passive vs Smart Beta Management 

The world has turned majority passive and simple portfolios built on a handful of passive ETFs have done extremely well in the last 15 years.  I however don't believe in putting all eggs in 1 strategy basket- also most cap weighted passive funds whether the investor knows it or not are using a momentum strategy which may have paid out  in the last 15 years. But every strategy has it's day.  Most importantly not all corners of the market favor a passive strategy. 

• Favoring active management for munis and REITs. Munis and REITs are a fragmented inconsistent market making passive less efficient. 
• Passive is okay if the fund has a decent dividend over 4% like VNQ so you can compound your returns
• Smart Beta hasn't beaten Passive Indexing because the last bull market in the last 10 years favored momentum investing style inherent in cap-weighted passive funds. I may reconsider adding back Smart Beta.

Income vs Value vs DGI vs Growth

1. favoring income right now in a expected sideways market which means I have a lot of closed end funds which give higher dividends due to leverage which I find the risk tolerable in a rate lowering environment 
2. value investing of the Warren Buffet/Charlie Munger school is always a reasonable choice but I don't have a sufficient process yet to recognize value traps. Judging by HeinzKraft, even Buffet gets it wrong.
3. dividend growth income/DGI- I haven't favored DGI right now as most desirable DGI stocks are overvalued. 
4. growth- still scouring for growth opportunities in future areas like battery technology, 5G,  cannabis(waiting for bottoming)

Geographic Diversification or NOT

This is a bone of contention for me as even Warren Buffet said investing in U.S. alone was sufficient due to multi-national nature of American companies.  For certain, I could have had better returns never investing outside of U.S. listed assets as Developed Market and Emerging Market indices and attendant ETFs have severely underperformed in the last 10 years compared to the U.S. markets. And as everybody repeats that the U.S. is the cleanest dirty shirt in the pile.

• Underweight Developed Markets
• Europe.  European Central Bank has less ammunition for fixing problems given negative interest rates, the special structure of the eurozone-i.e. individual nations can't print their way out of debt crisis like the U.S. can.  But the ailing national banks are a concern. If Germany the strongest of the EU has banking problems, you should pay attention. You only have to look at Deutsche Bank stock DB and index for European banks - Eurostox 7 SX72  looks dreadful as it's at a 30 year low, the current price is from 1988.   Other signs, perpetually problematic Italy was trying to print bonds in an alternative currency  in violation of EU agreements.
• UK- the British are kind of proud of their tradition of bumbling through chaos and that's the default hard Brexit scenario. There is a contrarian argument that British equities have been overly punished.
• North America- Canadian exposure 
• Japan - manufacturing recession 
• Korea - considered the canary in a coal mine is currently keeled over
• Underweight Emerging Markets- until I understand more.
• China - Cautious here. Massive over leverage at every level, China bank problems seem eerily reminiscent of U.S. banks in 2008 crisis. China manufacturing has slowed and Hong Kong conflicts are hard to resolve.  
• India- corporate tax cut always buoys the markets but I didn't bite.  Growth at a 6 year low with a lot of bad debts in their banking and shadow banking system.
• South America
• Argentina concerns of contagion. They've defaulted 8 times in 200 years. Current bond holders thought it's different this time.
• Brazil still volatile
• Keeping a watch on DVYE(7% yield). It has ~16% Russian exposure- I don't worry about the credit risk as Russia actually has healthier balance sheets than most DM nations but I'm not comfortable investing in a country that tried to disrupt our elections.
• Considering Frontier Markets as an EM substitute
• FM is the common ETF in this space but the 3.8% dividend is not worth the risk at current valuation, better off holding a federal muni which yields 4.5+%.
• FM/EM is not great in a strong dollar environment.
• U.S. vs State vs local  Munis
• Hard to avoid the worst fiscal states of Illinois, New Jersey, Connecticut, Pennsylvania  in a national muni as all of them have some exposure. They tend to be higher grade debt such as Chicago O'Hare airport or New Jersey Turnpike Authority which will not default outright.  Muni debt defaults are rarer than corporate defaults and tend to restructure. 
• Overweight California munis - the state's economy is stronger than most so I have taken the risk

Sector Diversification

You can look at the Schwab asset performance quilt that performance is a jumble- it's not so easy to pick out goats from the heroes as every sector takes their turn. However this does not mean that you have to make a stack of peanut butter sandwiches and you can do a more tactical allocation.  It's not as if every sector has an equal opportunity to win the race- some sectors have well known handicaps.

Developed Markets- if you had to bet on a marathon runner and old man Europe is known to have a chronic cough from decades of smoking, a heart condition and an upcoming nasty divorce, well you don't have to bet a lot of money there.    Odds are not in your favor and the upside in the slim chance there is one is going to be small.  However if things go pear shaped...  It's not that I wan't to pick out the winners, I am more interested in limiting downside than capturing upside which means avoiding a few areas:

• corporate high yield - mostly a no go zone for me
• DM- Avoiding Europe except for infrastructure exposure as nothing good can come from so much negative interest rates.
• financials - preferring preferreds over common
• health- political risk 
• tech- you are forced to be overweight tech in the S&P500 or any large cap index due to apple, microsoft, netflix, Facebook, google which have disproportionate weighting so I don't invest specifically in tech

Capitalization Diversification

The market capitalization of an asset has different implications for individual stocks vs.  funds.  If I was investing in a specific company, I should choose the company based on the merits of the company's long-term prospects and not based on capitalization.  With funds, I want to be exposed to all capitalizations but again there is the matter of allocation.

• mega-cap($200+ billion)
• large-cap ($8.2-$200 billion)   
• mid-cap ($2-$8.2 billion)
• small-cap($250 mil-$2 billion): small-caps tending to be domestic are more impacted by an economic cycle and have less resources to recover. Russell 2000 was markedly slower to recover since the 2018 downdraft.
• micro-cap(<$250mil) - so thinly traded, these are highly volatile

If using a passive index fund strategy, for the equity portion, is it better to use specific buckets of different caps or just a simple total market index?  You can point to outperformance or underperformance of large cap S&P 500(SPY,VOO) and total market funds(VTI) cherry picking time periods. Since S&P 500 tends to be about 80% of the total market, they are highly correlated.  In the past, I've mindlessly split equally between S&P 500 and total market and is good enough for me as it's the overall allocation to equities that matters more.

"Smart money" obviously allocates capitalizations based on business cycle and keeps all those macro-economists employed. The current tail end of an economic cycle is not a good time to be in all capitalization categories. I've heard over and over from on CNBC that smaller companies are less able to withstand a downturn and are exposed to credit risk as they have levered up significantly in this cheap money environment. But I need to dig up more data and consider if it's worth tweaking a specific strategy.

 In closed-end funds, capitalization plays an outsized role in liquidity and daily volatility and smaller cap funds have better arbitrage opportunities as they sometimes go on brief sales unrelated to specific news.

Tax Diversification

• Save in different types of taxable and non-taxable accounts. I have 3 types of retirement accounts Roth/Traditional/401K Solo that I optimize for the year.
• Employing taxable munis(in non-taxable accounts) and non-taxable Munis everywhere

Fund sponsor diversification

More relevant with CEFs/muni funds due to sponsors tending to pool dividend cuts so I rotate between Blackrock/Nuveen/Pimco/Eaton Vance pending z-scores/coverage ratios/call risk/and other factors. In choosing passive ETFs, there are slight differences in expense ratios and drift but plenty of investors had huge success sticking only to passive Vanguard ETFs.

Diversification vs Intensification

There is a skinny contrarian argument that can be made for intensification since diversification dilutes the downside as well as the upside. Some level of intensification can work for people who have a deep expertise. I could have bought 4 houses on the cheap 20 years ago and  handily exceeded all the stock market indices.

Diversifying Financial Information Diet

Investing is about acting on knowledge and being informed and so it's important to get diversification in "how" you know. I try to ingest a varied diet as possible. I don't have to agree with most of the financial pundits out there but it's supremely useful to constantly challenge my entrenched biases. I take a steady diet from these sources:

• traditional and new media for daily feed 
• old wall: WSJ, Bloomberg - left and the right to balance out
• new: cnbc, yahoo financial
• public: NPR Marketplace 
• crowdsourced
• seeking alpha - the first place I look before making an investment decision as the nature of crowd-sourcing ensures I get a wide spectrum of diverse opinions. I would say seeking alpha was probably the single most useful in making concrete investment decisions for fixed income
• bogleheads forum - if you go here, you know what you're getting
• reddit
• industry experts/hedge fund managers/contrarian views
• real vision
• sell-side institutions - all the investment management firms provide education and publish market analysis  
• Fidelity - has a decent library of learning videos and also provide live webinars that anyone can register
• different formats
• books from different decades, Benjamin Graham(1949), Peter Lynch(1980s,90s) still useful reads.
• podcasts such as Adventures in Finance, Grant's Interest Rate Observer

Concluding Thoughts

After going through this analysis,  I realize time diversification is the most important and hardest to achieve.  I kick myself for not getting serious about investing earlier but better late than never. And given free trade commissions, it's easier than ever. At least I had some common sense about squirreling away acorns for the long winter which is half the battle.