EC Diversify At Your Own Risk

In “What, Me Worry” we noted that the closely watched equity volatility index (VIX) was at a level of investor complacency rarely seen, not only in election years but over decades of market history. We also mentioned anxiety surrounding the upcoming election is palpable, and that equity valuations are at rarefied levels without supporting earnings and economic data. Given these factors, we ended the article with the following: “The market, courtesy of complacent investors, is offering very cheap insurance for an event that has the potential to induce extreme volatility via VIX options and futures. Even if the next eleven weeks leading to the election prove to be uneventful, the VIX at current levels, as shown earlier, has been a prudent place to own protection. We recommend you consider this opportunity as a protective measure”.

Unfortunately, most professional investment managers are not adept and/or able to trade VIX futures, options or volatility in other forms to hedge their client’s equity positions. More often than not, concerned managers will instead reduce perceived risk by selling a portion of their equity holdings and increasing cash positions and/or shifting portfolio allocations from equities to fixed income. It is in this vain that we discuss how the latter option, shifting money from equities to fixed income, has risks that were not as evident during the 2000 tech crash and the 2008 financial crisis.

MPT

Harry Markowitz developed the Modern Portfolio Theory (MPT) in the 1950’s. Simply put his theory argues that portfolio risk can be reduced by holding combinations of different securities and asset classes that are not positively correlated. We agree with the theory that there are benefits to diversification but we do not subscribe to MPT. Diversification makes sense when you buy uncorrelated assets that are undervalued. Buying assets for the sake of diversification without regard for valuation is fraught with risk regardless of how many different securities and asset classes one may hold. In the words of Warren Buffett, “diversification is a protection against ignorance. It makes very little sense for those that know what they are doing”. To paraphrase Warren Buffet, diversification is for those that do not know what they are doing.