Diversification with Inherent Assets in Mind


Chances are, the successful individual investor keeps these basic ideas in mind for the long haul: be disciplined, save and invest as much as possible, be mindful of taxes, don't get caught up in the latest market mania fashion trend, and keep investments broadly diversified.

Diversification. Let's take a closer look at this sacred virtue of the buy-and-hold investor.

The goal of diversification is simple - invest broadly and accept the returns of the entire market. Of course, this is your goal if you believe markets are efficient and that stock-picking is a loser's game in the long run.

The path to a broadly-diversified portfolio involves a careful examination of one's assets to form a clear picture of which asset classes are underweighted or overweighted. For example, a heavy allocation in technology or real estate could end up being painful if the sector goes in the tank. Investors who sleep best at night have their investments spread out to cover a big chunk of the market.

But many individual investors are hitting a big pothole on the road to diversification. Too many investors are failing to recognize how inherent assets figure into their overall portfolio. When evaluating how well diversified their portfolio is, most people look only at their investment assets, which might include cash they have in equities, fixed income, and real estate. However, inherent assets - things like salary, employee stock options, inheritances, even physical health - are also important when considering an individual's entire wealth allocation.

According to Diane Garnick, Equity Derivatives Strategist at Merrill Lynch, focusing on inherent assets is crucial because they vary much from person to person. So, when making allocation decisions regarding equities, there is no one-size-fits-all strategy. The main danger in ignoring how inherent assets affect a portfolio is that they may correlate with investment assets, which compromises diversity.

"Portfolios should be structured so that investment assets complement, rather than duplicate, inherent assets," says Garnick.

Consider the following hypothetical example.

The Tech Double Whammy

Let's paint a picture of of an average young tech company employee with stock options. Since I live in San Francisco, this should be a relatively easy task. Let's say he's 27 years old, has a time horizon of over 20 years, and has a portfolio with 80% equities, 15% bonds and fixed income, and 5% cash. Let's call him DotComGuy.

DotComGuy's Equities Weightings
Industrial Cyclicals


Of course, DotComGuy's sector weightings are his own and he wouldn't necessarily recommend them to others. DotComGuy feels pretty good about his portfolio and is prepared to stay the course he has chosen through thick and thin.

But when constructing his portfolio, DotComGuy neglected to factor in his inherent assets - the fact that he works in tech, and that he has stock options in his company. He is overweighted in tech, and is set up for a hard fall if the sector underperforms. What is DotComGuy to do?

Since he is overweighted in tech, he needs to rebalance and find sectors that have a low correlation with tech. Because the technology sector tends to be heavily weighted towards growth, DotComGuy would be well served looking into value.

The table below lists the correlation of the tech sector with other S&P 500 sectors over the entire 1990s.

Correlation with Tech sector
Capital Goods
Consumer Cyclicals
Basic Materials
Communication Services
Consumer Staples
Health Care

Source: Merrill Lynch Equity Derivatives Research

To ensure his portfolio is broadly diversified, DotComGuy would want to rebalance out of tech and into a sector that has a low performance correlation with tech, like the sectors at the bottom of the above table.

The situation can be taken one step further. Let's say DotComGuy has a nice live/work loft in San Francisco's South of Market district. He counts this as exposure to real estate, and it looks like a good investment given the skyrocketing real estate prices in the Bay Area in the 1990s.

Median Home Prices, San Francisco Area, 1988-1999

: National Association of Realtors

However, real estate prices are tied to the local economy, and in San Francisco it's technology. During the dot-com buildup of the 1990s, it was the migration of highly-paid tech workers to the city that primarily drove up real estate prices. If the tech sector were to tailspin (it is), those local companies would have to lay off workers (they are), and real estate prices would eventually cool off (they might).

The situation could conceivably get even worse - imagine that DotComGuy finds himself a victim of the tech sector job cuts.

The Big Picture

The above situation is a simple example of how disregarding inherent assets can wreak havoc on an otherwise well-diversified portfolio. I could have just as easily chose a mother of two with employee stock options working as an executive at a big bricks-and-mortar company in Atlanta. Again, there is no one-size-fits-all asset allocation formula. Many factors must be considered when building the right portfolio for an individual, and the variables are subject to change. For example, Garnick recommends reevaluating every five years, or after a major life event like a move or job change.

And as always, choosing cost-effective ways to implement a customized portfolio strategy is critical for success.