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17th Feb 2021 | Michał Karol Ejdys | Investment Product Development Project Lead

Learn about asset diversification from a ballet dancer

Stanford University’s $29bn endowment fund, one of the largest in the US, is managed by a former ballet dancer, with 16 years of experience in a dance studio and on stage. His fund delivered more than 5% annually lately, while median competitor score was just above 1.5%. A good manager he is, a talented one, possibly. How else would such robust returns be explained with so much lifetime of this individual spent in a field not remotely related to investing? 

In his own words, in a recent Financial Times article, Mr Robert Wallace delivers an answer: disciplined adherence to the target allocation of capital among asset classes. Reducing or increasing positions whenever they move too far from the agreed upon template. “The day-to-day work is not that different than walking into a rehearsal studio at 10 in the morning, and spending the entire day trying to get a little bit better”1, he says. 

The three factors of success

From the three sources of success in life – hard work, talent, and luck – the Stanford’s fund manager focuses on the first one, consciously avoiding the subject of natural skill and decreasing his reliance on chance. What he is doing, is the investing analogue of hard work in life – diversification.

People say, “there is no such thing as a free lunch” and that is true in financial markets also. Can’t get your lunch for free, i.e., can’t get meaningful returns without risk. However, what you can do, is get a discount on your lunch, if you bring a loyalty card with you. For the same potential return, you can reduce your risk, so long as you diversify.

We will leave the mathematical proof to a scrupulous reader. We will leave the proverbial reasoning behind not putting all eggs in one basket, too. It is just as less likely that two things that behave randomly, will behave in the same way at the same time. ‘More things’ equals less exposure to randomness of each of them, which in turn translates into more exposure to randomness of… well…? What exactly? 

Once you eradicate the randomness (termed idiosyncratic risk) of each individual position in your portfolio, what you are left with a common risk factor – market risk. Financial theory supports the argument that this is the fair price you should be willing to pay for the returns you want to achieve.

That is the price of your lunch - if you are anything like Robert Wallace, and a number of other successful portfolio managers who think about investing as a science rather than art. They do not gamble. They work. 

It is true that it sometimes happens that somebody makes a higher return with one concentrated position, without diversifying, and the position only goes up as if there was no risk. But that is just that. It. Sometimes. Happens. To. Somebody. 

That is either talent or luck, if we are considering the three factors of success mentioned earlier. Sounds strangely like luck to me, but for the sake of the argument, let us assume it is talent. By now we should all know talent is not persistent in financial markets. So even if to some it seems like it could be talent – it is most definitely luck. So how do you become lucky?

I don’t know. If you know, that’s fine, but Mr Wallace and I will stick to diversification and other tiresome but proven methods of allocating capital. 

There are several angles to talking about diversification. Best to show them on examples. Let us take an equity investor, who diversifies by buying several stocks. Usually 20-30 is more than enough. 

However, it is not the number of assets she holds that provides diversification, but correlation between them, or, more precisely, the correlation between underlying risk factors. If she holds Coke and Pepsi, she diversified away the risk of one of the companies’ board member having an accident, while retaining most of the sweetened soda drinks sector risk. More examples: Boeing with Airbus, Dell with HP, Ryanair with Wizzair etc. These companies are very similar, and hence expose the investor to the same set of risk factors, providing little diversification. If only there was a way to hold these risk factors without selecting the companies by hand… Enter ETFs.

Gain exposure to certain sectors, countries or even the whole world

Exchange Traded Funds (ETFs) are passively managed funds that have very low fees and usually track some index composed of many different assets. Using this tool, instead of buying Coke and Pepsi, our investor would be better off buying some ‘Soda Producers ETF’ (there is an ETF for almost anything nowadays). This way she knows exactly what she is getting – exposure to soda drinks sector, with individual companies’ risk diversified away. 

Careful Reader is probably tempted right now to consider switching from a Coke, Pepsi, Airbus, Boeing, Dell and HP portfolio to one holding Soda, Airplane and PC producers’ ETFs. This is another move towards greater diversification. What would be diversified away this time is sector risk. This, too, can be done easier – by buying an ETF for the whole market. Market ETFs (SPY being most notable) hold all assets traded in some market, in proportions equal to their share in total capitalization. They are amazingly cost effective and provide great diversifications if you want to hold stocks from this index but do not want to worry about any of them going bankrupt suddenly, for example. Because if one goes to zero, you have the other S&P 499, for example.

Last level of diversification in the classic sense, investment-wise, is to hold several asset classes. These are broadly speaking equities, fixed income (think: bonds), commodities, real estate, and private equity. Some go as far as including human capital, too, and this is indeed a valid choice. Anything you can invest your capital (time, money) and expect future benefits is an asset. Therefore, a careful investor should diversify between any asset that is somehow different form another (not perfectly correlated) and reap the benefit of not being dependent on any single one. There are ETFs for that, by the way (except human capital, got to get that certificate in Spanish / coding lessons / PhD diploma all by yourself).

Diversify more than just your investments

One last level of diversification is to use it in everyday life. It is convenient to have one bank account, but safer and more future proof to have a couple. Banks do fail, from time to time. Perhaps you bank accounts should be in more than one country, to diversify political risk? Countries introduce unexpected taxes and all sorts of rules hard to foresee, too. It is inconvenient, that is true – you have to fill out all the forms, read all the terms & conditions multiple times, but can save you a lot of hassle when something does not work as intended. Perhaps this inconvenience is the price of diversification?

Mr Wallace mentions disciplined adherence to target allocation among asset classes as the explanation of his great results. That is diversification right there. He has a blueprint, a target allocation: e.g., 33% in each of US equity, US bonds, World equity. A diversified portfolio, without concentrated positions. Once such a portfolio is bought, it has these exact proportions – but each day, prices change, and a dollar of US equity yesterday, today is worth $1.20, let us say. What Mr Wallace does then, is he rebalances the portfolio. Sells the assets that suddenly grew above their target allocations and uses the proceeds to buy these which happen to become underrepresented. He keeps his portfolio diversified as intended. Does not let it grow concentrated in any of the asset classes. Day-to-day work. 

The bottom line

So, there we have it: the mystery of Robert Wallace, the ballet-dancer-turned-fund-manager, resolved. The Stanford endowment fund, under his command, can deliver more than double the competitor’s performance, yet he quotes (albeit indirectly) diversification, which anyone can do with enough perseverance, as the core reason behind it. Some sources of success in investing are possible to control after all.

References

Financial Times (2020), Stanford endowment chief applies ballet discipline to investment


​​​​​​​Notice: Golden Sand Bank ("Bank") exercised due diligence to ensure that the information contained in this publication was not incorrect or untrue as at the date of publication. All Investment products are at risk, as their value can go down as well as up. The tax treatment of your investment will depend on your individual circumstances and may change in the future. If you are unsure about whether investing is right for you, please seek financial advice. This publication is not an investment recommendation or investment advice in connection with any services provided by the Bank to the Client.

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