Diversification is Not Enough to Manage Risk

Diversification is Not Enough to Manage Risk

Posted on December 06, 2016
Weekly Update

Market State 1: Bullish (18 trading days): Market State 1 represents a long and short-term bullish environment.  The market had been in an overbought condition for over three weeks. Last week most stocks declined and as a result, the market is no longer overbought.
Canterbury Volatility Index (CVI 48): Volatility, as measured by the CVI, has remained low and stable after the wild moves following Election Day. Keep in mind that Canterbury studies show evidence that a range of about CVI 50 to CVI 75 is optimal. The current CVI 48 is slightly below the optimal range. We are getting close to a point where the probabilities of an outlier day, or two, are likely.
Market Comment:
The NASDAQ Composite took a hit, down -2.7% while the S&P 500 declined -1%. The Dow ended up 18 points for the week and put in a new high at 19,192 on Thursday.  New highs are always good but keep in mind that the Dow was at 18,313 on May 19, 2015.  That means that the Dow is up a little under 5% in a year and a half while suffering two declines in the -13% range. That is not a very good risk and return relationship.
Speaking of the risk/return relationship, which of the two ETFs in the chart below would you consider conservative and which one is risky?

The graph with the black line seems riskier that the blue line.
  • The black line has a wider range, between its High and Low, than the blue line.
  • The black line has higher volatility (CVI 78) than the blue line (CVI 48).
The Black Line is the U. S. Treasury Bond ETF (symbol TLT) Bearish - Security State 12
The Blue Line is the S&P 500 Index ETF (symbol SPY) Bullish - Security State 1
The Canterbury process does not accept the traditional belief that some asset classes are more or less risky than another; i.e. “bonds are safer than stocks.” In the example above, bonds are riskier than stocks. In other environments, the opposite could be true.
The Canterbury Portfolio Thermostat evaluates each ETF as if it were its own asset class. Any ETF listed as being in one of the “bullish” - Security States would be less likely to have a decline more than the normal expected market noise and is therefore considered “conservative.”  On the other hand, a “risky” ETF is one that is experiencing high or increasing volatility. High and increasing volatility is a primary “bearish” characteristic reflected in those ETF securities that have a high potential for significate declines (drawdown).
Therefore, in the chart above, the Treasury Bond ETF (TLT) is in bearish - Security State 12 and is currently a risky security. TLT would not be an appropriate holding for a conservative or moderately conservative portfolio. While, on the other hand, the S&P 500 ETF (SPY) is in bullish – Security State 1 and is currently a lower risk/conservative security.
Risk Tolerance Should Not Determine Asset Allocation and Diversification 
The Portfolio Thermostat manages risk by owning a group of efficiently diversified ETFs that exibit quantifiable bullish trading characteristics. The most efficiently diversified portfolio is the one that can produce the highest returns, over the long run, with the least risk. Efficient diversification is not achieved through “buying and holding” a wide varity of ETFs that represent many different asset classes.
All liquid ETFs will experience both bull and bear market environments. Therefore, the most efficiently diversified portfolio should systematically adjust ETF holdings over time. Such a process would require an evidence based tactical process to optomize asset allocation and diversification to reflect the changing market environments.
The practice of establishing a fixed asset allocation and diversification, based on a subjective view of “risk tolerance,” is a myth. Taking more risk does NOT produce higher returns in financial markets.  
The universal definition of risk, in financial markets, means accepting larger declines (drawdowns) and higher volatility. How does suffering large declines help one make more money? As stated earlier, high volatility is a primary characteristic of a bear market or a bubble. Bull markets tend to be more stable.
Bottom Line:
The theory of taking more risk to make higher returns can be true for a direct owner of an “illiquid” business. The same is not true for the ownership  of “liquid” traded securities of publicly owned companies. The direct ownership of a business is typically a long term commitment  and requires daily management of its opperations. On the other hand, financial securities are liquid and, as a result, the changing supply and demand for the shares will eventually cause bear markets. Therefore, NOT taking advantage of a security’s liquidity to avoid losses (meaning buy and hold) will eventually lead to substantial losses over the long run.

Canterbury Investment Management: Tom Hardin

More About Tom Hardin
As Chief Investment Officer, Tom has more than 30 years of experience in the investment management industry and has a broad breadth of knowledge. He is known as an innovator, educator and has been revolutionary in the advancements of portfolio and risk management.

Every effort was used to provide accurate data and mathematical calculations to provide, what we believe to be, accurate results. Canterbury Investment Management, LLC, and its principal owners, make no guarantee of completeness or accuracy of data or calculations as well as conclusions of any statistical data or information contained in the simulation illustrated on this page. Past results or performance is in no way a guarantee of future results.