Investing Caffeine

Super Sizing May Be Hazardous to Your Portfolio’s Health

October 8, 2009 at 2:00 am 2 comments

You may be familiar with the 2004 Academy Award nominated documentary titled Super Size Me, in which the creator Morgan Spurlock decides to film his 30 day journey of eating McDonalds (MCD) for breakfast, lunch, and dinner, making sure he samples every item on the menu. In addition, any time a McDonald’s employee asked Mr. Spurlock whether he wanted to “Super Size” his beverage or French fry order, he complied by ordering the larger size. What was the result from this gluttonous, month-long, fast food binge?

Mr. Spurlock ended up gaining about 25 pounds in weight, his cholesterol sky-rocketed, his liver function deteriorated dramatically, he experienced heart palpitations, and became depressed, among other symptoms. At one point a doctor told him if he continued overindulging at the same pace, he could die.

Well, over the years, investors, governments, and corporations have been doing their own form of “Super-Sizing,” but not by eating Big Macs, Apple Turnovers, and Fish Fillets, but rather consuming too much debt, real estate, and other risky assets, like stocks and hedge funds. Now, like Morgan Spurlock, investors are “de-toxing” by saving more and creating a better balanced portfolio diet. Investors have learned their lessons from our “Great Recession” and are dieting on lower risk assets  and consuming a broader set of asset classes. An investor’s diet should cover a broad spectrum of options, including diversified choices across asset class, size, style, and geography. Alternative asset classes, like real estate, commodities, and loans should be evaluated as well.

After the massive crash post-Lehman Brothers, many investors and academics have cast doubts about the relative benefits of diversification, arguing there was no investment class or segment to hide – everything fell equally. There is some truth to the argument, with some exceptions like treasuries, cash, and certain commodities. Globalization and the tighter inter-connectedness between countries can shoulder part of the blame of the synchronized freefall in late 2008 and early 2009. Nonetheless, unless you were short the market, even if you were relatively diversified, pain was spread out generously across many investors.

What countless investors fail to recognize is the constant variability in historical relationship data (e.g., correlations, standard deviation, and covariance) – all the better reason to be broadly diversified. Nobel Prize winners Robert Merton and Myron Scholes know first-hand what can happen when you rely too heavily on historical correlations. Their over-reliance on their quantitative models led to the economic collapse of Long Term Capital Management, which nearly brought the entire economic globe to its knees. Importantly, the magnitude of diversification benefit varies throughout an economic cycle. Since the market rebound in March of this year, we have clearly seen the advantages of diversification.

From a geographical perspective, emerging markets like Russia, which is up over +117% (excluding dividends), are trouncing the domestic averages. Diversification benefits across particular industries and sectors are also evident in areas like technology. For example, the NASDAQ and IIX (Internet Index) are up about +34% and +52% in 2009, respectively. In relation to style characteristics, “Growth” is trouncing “Value” as measured by the Russell 1000 Growth and Value benchmarks. “Growth” is up +25% this year, more than double the appropriate Russell “Value” benchmark. It comes as no surprise that the conservative investments that outperformed in the market collapse, like fixed income and utilities, have generally lagged the other segments.

Like Morgan Spurlock, investors need to resist the “Super Size” temptations in their concentrated portfolios and learn from the binging mistakes experienced by others. A more balanced investment diet across asset class, size, style, and geography will lead to a healthier portfolio and steadier return profile. Now if you will excuse me, I would like to get a bite to eat – perhaps a wholesome McGarden Burger.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management has a short position in MCD at the time this article was originally posted. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Entry filed under: Asset Allocation, Education, Financial Planning. Tags: asset class, diversification, geography, McDonalds, Morgan Spurlock, size, style, Super Size Me.