(MoneyWatch) Financial Advisor magazine highlights a report admonishing advisors who thought diversification would save their clients’ portfolios from difficult markets. Unfortunately, this represents a misunderstanding of the way financial markets work.
The report, by New Jersey investment firm Risk 3.0 Asset Management, said that “advisors have not understood the impact of what can only be seen as a historic and seismic shift in global financial markets and what that means for their clients and their business.” It also called out advisors for their views on diversification, saying “they still think that diversification is the answer and is going to save them, even though diversification didn’t save anybody in 2008.”
The root of the problem is that the report’s author doesn’t understand modern portfolio theory very well. Here’s a quick breakdown of the four major components of MPT:
Markets are too efficient for active managers to consistently exploit them for profit
Over the long term, asset classes typically provide returns according to their levels of risk
Diversification can increase returns or reduce risk (In some cases, it can actually do both)
There’s no perfect portfolio; there is only a portfolio that is suited for an investor’s given level of risk and expected returns.