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November 12, 2012 at 05:40 AM
In the school of money management, there are a number of different approaches. Most believe managing a portfolio consists of some percentage art and some percentage science.
I suppose the science part could be relegated to a computer model. However, the portion of portfolio management which is dedicated to “art” requires a human being. Off the top of my head, I can think of at least one ETF and one mutual fund that discounted the “art” portion and relied solely on a computer model to make all decisions. In these cases, I learned a valuable lesson: you cannot and should not discount the human element. In each case, there were significant periods of underperformance. Hence, I believe that a good quality money management approach requires some degree of art and science. Then comes diversification.
Diversification
Can a portfolio be too diversified? I used to think not. But today, I believe the answer is yes. Consider this. Investment A (the S&P 500 Index) and Investment B (S&P 500 Bear Market Fund) react exactly opposite to each other. In essence, they are perfectly negatively correlated. Therefore, as A rises, B falls, and vice versa. At the end of a specific period, your portfolio essentially has a zero return. This is because they cancel each other out. To correct this, you would have to select two investments with positive returns over the exact same period. Assume C and D both have an average three-year return of, say, 8.0%. In this case, the portfolio would have a positive return, but it would be impossible for these investments to have a correlation of negative one.
