It's the outdated investment strategy, stupid.
To Lee Munson, former speculative trader and now head of his own New Mexico-based asset management firm, Portfolio LLC, investors may be being deprived of sound, productive investment advice because some advisors still follow a longstanding financial credo espoused by Wall Street he contends is now obsolete.
And Wall Street, claims Munson in his newly published book Rigged Money, wants to keep it that way. Munson says the financial industry has convinced the general public that investing across different asset classes is the only way to protect their wealth.
"But this is an outdated rule that no longer applies, since asset classes -- small caps, large caps, international investments, gold and bonds -- now overlap," Munson says. "When it comes to risk and volatility parameters, the diversification effect is gone."
Munson also takes a dim view of diversification of portfolios based on a pie chart, suggesting that asset classes move in tandem with one another, not independently. In addition, Munson says he doesn't like Wall Street's push to include gold in portfolios because the metal doesn't produce capital or anything else that's useful.
Munson, who worked as a speculative trader during the dot-com boom and bust, says he afterwords had an epiphany about financial markets and began to question everything about his approach to investments.
"The big switch that we've had over the last ten years is realizing that we can't rely anymore just on 'correlation,'" Munson says. "Correlation is great; it's the icing on the cake -- we all do it; we still need to do it. But it doesn't cure the illness of risk volatility that is constant."
Investment correlation is the extent to which the values of different types of investments move in tandem with one another in response to changing economic and market conditions. Correlations are typically used in advanced portfolio management.
"Risk is really the key driver; and that's what makes correlation relevant or irrelevant," Munson said. "And I think if you keep clients on a long-term plan, the plan that they don't want to do, advisors need to keep risk constant, which they refuse to do -- they only want to talk about correlation. And then clients say, 'Wait a minute; I feel something is wrong.'"
Munson says financial advisors need to switch from a product diversification and correlation mentality to studying market risks.
"That's where advisors could do a little bit better -- talk about risk first, and then say, 'Yes, then we are going to diversify,'" Munson says. "It's not training the market -- it's being pragmatic. It's saying I have to keep risk at 10 percent. Investors will buy into their advisor's plan if they guarantee that they can keep risk constant."
Munson says financial advisors also need to get off gut instincts and get re-acquainted with math, and reality.
"Advisors stumble around in the dark without understanding the math of the concept, all because they still buy into the big lie that correlation is the Holy Grail of all things," Munson said. "And the risk thing, they're either raising or lowering the risk, not keeping risk constant."
"You need to update from 1956, folks. Diversification is the second-most important thing that you need to be doing with your clients," Munson added. "The first thing that you should be saying is, 'What is the actual risk? What is the standardized, annualized volatility?"
-Jim McConville