Beware overdiversification

Benj Gallander, Ben Stadelmann, and Philip MacKellar
Thursday November 16, 2017

There is a common investing trope that holds that a monkey throwing darts at a board will do better than a financial adviser. Obviously, this is not complimentary to professionals in the financial field, but rumour has it that the simians do love it!

Just as in any sector of employment, there are first-class people and, let us say, those who are not as good. Okay, perhaps the latter is being kind. However, there is nothing surprising about this. Be it real estate agents, teachers, doctors, renovators, actors and all professions, some are better than others. Sometimes by a lot. This is the nature of vocations.

Recently, Benj was approached by his cousin, whom we’ll call Bill, who is not a Luddite when it comes to investing. But in terms of taking control of his own savings, he does not feel that he has sufficient knowledge and, like many people, not enough time. Bill wants to enjoy life after the long hours of his full-time job.

Bill’s bank recommended a financial adviser, and this gentleman made a proposal for Bill’s savings, which are just north of $200,000. Bill asked Benj’s opinion on a portfolio composed of:

  • companies including Amazon, Enbridge, Fortis, Algonquin Power & Utilities,
    Toronto-Dominion Bank, Bank of Nova Scotia, Medtronic and Maxar Technologies;
  • structured notes linked to the Euro STOXX index;
  • a preferred-share portfolio;
  • three US index exchange-traded funds that are hedged for the Canadian dollar:
    BMO Nasdaq 100 Equity Hedged to CAD ETF, BMO S&P 500 Hedged to CAD ETF and
    BMO Dow Jones Industrial Average Hedged to CAD; and
  • two emerging technology ETFs: Global X Robotics and Artificial Intelligence USD ETF and
    ROBO Global Robotics and Automation USD ETF (ROBO).
  • Benj was doubtful on many levels. Make no mistake: this is a great portfolio — looking through the rear-view mirror. But just because the investments have done well in the past does not mean they will continue to prosper in the future.

    In fact, the converse is often true as they regress to the mean. When picking investments, one has to focus on where things are going.

    Given how far the stock market has moved and these choices with it, when the market takes a beating, which of course it will, it is virtually a certainty that this portfolio will get hammered.

    Another problem that appears in the portfolio is the sheer number of selections. We’re great believers in diversification, but as Benj outlined in a chapter of his bestseller The Contrarian Inverstor’s 13 titled “Diversify, but Beware the Devil of Overdiversification,” if one has too many investments, they work against each other, thereby impeding returns.

    Overdiversification is more troublesome with this assortment of investments because three broad indexes are being currency hedged. On the one hand, this will add a form of protection; but it will also mute returns. Plus, hedging comes at a price because it is not free — further reducing the payoff.

    But wait. This may be hard to believe, but the Contra Guys do not always completely agree. When Ben looked at this portfolio, he said, “It’s rather interesting. I can see how the adviser would argue that it is balanced. Of course, one person’s ‘balanced’ is another’s all over the place.

    “You might find this strange, but I would argue this is an extremely defensive portfolio in terms of protecting the adviser’s reputation.

    Again, our idea of ‘defensive’ would be different, but I get where he is coming from. It covers market leaders, the broad market, hedges currency risk, uses utilities and preferred shares for ballast, and keeps an eye on the future. Investors could easily do far worse.”

    One portfolio, two very different views.

    One of Benj’s friends for more than 25 years was a vice-president at one of the major banks; at his peak he had more than 300 people working under him. He and Benj would enjoy their regular outings as they were working in very different worlds — one in the more stuffy world of Bay Street banks, the other (Benj) at home, watching the river flow.

    The two could talk “out of turn,” knowing that there would be no reprisals, especially for the VP, who was and remains somewhat of a renegade. He said a primary goal set for him was to get clients into investments that would strongly enhance the bank’s bottom line. If done well, that also meant higher salaries and bonuses for his people.

    Was this always in the best interests of clients? Suffice it to say that, all other things being equal, higher returns for the bank would mean lower returns for their clients.

    One long-standing debate is the “fiduciary duty” that advisers owe to clients. The question of acting in the best interest of customers is at the heart of this discussion. There is talk that all financial advisers should be fiduciaries, but that is not the case today. Certainly if they were, that would improve the returns for the average patron.

    If someone chooses to have a financial adviser, it is wise that they do some due diligence on their investments and ask the right questions, such as why the money is being allocated as it is.

    Recently, a reader asked, “What’s one of the most effective things you’ve done that’s made you a better investor?”

    Benj’s response was: “Reading, reading and more reading. And being willing to learn from my mistakes. Hey, that is more than one, non?”

    So, which portfolio would be farther ahead in five years: the financial planner’s or one chosen with darts thrown by a monkey? Time will tell. First, though, we’ll have to find a monkey with darts. Then, it’s game on!