When we left our normal life back in March 2020 (it seems like decades), most of us probably did not imagine we would still be working this way. The gravity of this crisis, and the weight of responsibility on the shoulders of those who help manage clients’ uncertainty are a lot to bear. 

Recently, my family and I decided to take some time away to recharge, and we were just grateful to be able to do so. I was personally thankful for down time to process much of what had been running in the back of my mind. I did not anticipate that a tropical storm would reinforce for me the value of diversification.

Water and electricity do mix

Diversification was the furthest thing from my mind when my family and I pulled up to our lakeside bungalow rental in Connecticut. We unloaded the SUV, changed clothes and immediately proceeded to fish off the dock outside, with s’mores later that evening by the fire pit. 

If you’re like me, you know it usually takes a couple of days to really relax. I needed time on the lake in a rowboat, a few naps and a game of pretend-café with my precocious 8-year-old daughter (who sued me for not having the right pretend money to cover my bill). By the third day, I was finally starting to feel relaxed. 

Then the storm came. We did not anticipate how powerful Isaias would really be. It started off as a light rain, then turned into pouring rain, dark skies and high winds, whipping plants, branches and whole trees alike without regard for consequence. We hunkered down, and turned off the A/C, determined to enjoy the time indoors. But without warning, the room darkened, the TV shut off and the white noise from random appliances and other electronics was silenced. We were sitting in the dark. 

I know this seems like a natural transition point for the ultimate reference to diversification, but it’s not. We were on what had been a serene lake. We enjoy camping and we have flashlights and headlamps, so we were content. But at some point I made my way to wash my hands and the water went from flowing freely to a slow trickle, then to a drip, and then to nothing. Our bungalow’s well was dependent on electricity to pump H2O. The next morning we made our way home and turned our vacation into a staycation. 

Rentals and risk management

While some parts of the travel industry have been negatively affected by COVID, others are seeing growth. Sales of some recreational vehicles have spiked1. We spent two weeks looking for a rental that fit our requirements and the vast majority were booked solid through Labor Day. The bungalow we ended up in was nice and cozy, and the hosts managed it like a nice hotel room judging from the treats that were there when we arrived. We embarked on the three-hour car ride home after our web-connected security cameras came back to life, indicating that we had both water and power available at home. 

I couldn’t help but think about the situation the host was in. It seems likely that it wasn’t the first or the last time they’d deal with this issue. I can’t imagine a better scenario to justify the return on investment (ROI) for a standby generator. 

Sure, if you amortize the cost of a generator over some reasonable period, their net income would be lower. That said, I can’t imagine a scenario where – over the long-term – giving up the additional return in order to reduce risk wouldn’t leave them better off than not having installed the system. That’s an argument without some needed context. It’s probably important to note that, over the course of a 20-minute detour through winding back roads strewn with debris, we saw no less than 5 massive fallen trees that had taken out power lines. In an area that is densely populated with trees, where transmission lines are precariously threaded among those towering, yet sometimes frail, giants – it might be worth finding a way to manage the risks that could result in significant loss.

What Isaias reminds us about diversification

Investing in equities is like owning a vacation rental whose profit maximizing potential requires (mostly) good weather, or at least “not-too-bad” bad weather when normal storms do appear. However, inevitably, there’s an Isaias, and then the cost of not having taking taken steps to reduce risk rears its head. It’s the cost of not giving up some profit potential in exchange for reduced risk. 

The cost of not giving up some profit potential in exchange for reduced risk

the cost of not giving up some profit potential in exchange for reduced risk

Annual returns from 2009 (to establish best- and worst-performing asset classes going into 2010) through 2019. At the start of each year, the hypothetical Return Chaser strategy invests 100% in the best-performing asset class of the prior year (Cash in 2019), the hypothetical Contrarian strategy invests 100% in the worst-performing asset class of the prior year (Emerging Equity in 2019), and the hypothetical naïve or 1/n Diversifier strategy invests equally in all asset classes. Asset-class proxy indexes: US Large = Russell 1000, US Small = Russell 2000, Int’l Equity = MSCI EAFE, EM Equity = MSCI Emerging Markets, Core Fixed = Bloomberg Barclays Aggregate Index, High Yield = Bloomberg Barclays US Corporate High Yield Total Return Index, EM Debt = JP Morgan EMBI Global Diversified, TIPS = Bloomberg Barclays 1-5 Year US TIPS Index, Commodities = Bloomberg Commodity Index, Long Duration = Bloomberg Barclays US Long Government/Credit Index, Short-Duration = ICE BofA 1-3 Year US Treasury Index, Cash = ICE BofA USD 3-Month Deposit Offered Rate Constant Maturity Index. Sources: Index providers, SEI. Past performance is not a guarantee of future results.

Investing in that backup generator is like taking a portion of a 100% equity portfolio and investing it in bonds. Yes, you give up the profit potential you would have if you invested 100% of your money in equities — but that potential can only be realized when things work out the way you hope. Over time, you’re most likely going to be better off having opted for diversification. 

By diversifying power sources between the utility lines and the generator, over time, rental net income can be maximized relative to your income when there is no generator, or when you rely solely on a generator for power (which would be noisy, expensive and probably very annoying). 

I was reminded of a webinar we did in January of this year. It was entitled “2020 Market Outlook: No Boom, No Bust, No Bear.” In it, my colleague Ryan Schneck, our director of client portfolio strategy, shared a simple example of the benefits of diversification (shown here in this figure). He shows a “Return Chaser,” a “Contrarian,” and a “Diversifier.” These personas pursue a range of investment strategies, described here, resulting in the annualized levels of return and volatility you see in the chart. In my example, the Return Chaser buys the rental on the lake, relying solely on power from the utility. Conversely, the Contrarian only buys a generator. Finally, the Diversifier invests in both. In Ryan’s example, the Diversifier had the best financial outcome. I’m convinced that my vacation rental Diversifier would experience similar benefits.

So, the moral of the story is simple. Collectively, our clients rely on us to help them to navigate various risks and to achieve their financial goals. It’s important we never forget the importance of diversification.

https://www.bloomberg.com/news/articles/2020-05-26/-covid-campers-rv-motor-home-and-travel-trailer-sales-shoot-up.

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Legal Note

There are risks involved with investing, including loss of principal. Diversification may not protect against market risk.

Index returns are for illustrative purposes only and do not represent actual investment performance. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.

The standard deviation is a statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance.

A return chaser is a person who buys financial investments only because they offer high yields or interest rates.

Contrarian investing is an investment style in which investors purposefully go against prevailing market trends by selling when others are buying, and buying when most investors are selling.

A Diversifier is someone who uses a risk management strategy that mixes a wide variety of investments within a portfolio.

Information provided by Independent Advisor Solutions by SEI, a strategic business unit of SEI Investments Company. The content is for educational purposes only and is not meant to provide investment advice or as a guarantee of any specific outcome. While SEI welcomes comments, SEI is not responsible for, and does not endorse, the opinions, advice, or recommendations posted by third parties. The opinions expressed in comments are the view(s) of the commenter(s), and do not represent the views of SEI or its affiliates. SEI reserves the right to remove any content posted by users of this site in its sole discretion.

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