My comments: I interpret the phrase, “money management” to mean everything necessary to help a client get from point A to point B with more money than they started with. All of us in the investment advisory business work hard to understand all the variables, and apply them intelligently to the needs of the client. Well, perhaps not Bernie Madoff, but most of us.

We’re well into a period in time when the prevailing sentiment and resulting performance has been mostly sideways, not upward. So the trick for me, has been “money management” that made sure the down times are limited so that when the up times re-appear from time to time, you’re starting from a higher point. I strongly believe that over the next few years, we’re going to be able to tell ourselves we’re in another “up” zone where all of this becomes less important. But we’re not there yet.

So while the author of this article is focused on diversification, there’s a lot more that has to happen to improve your chances of getting from point A to point B with more money.

By Mike Patton | November 12, 2012

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.

A few years ago, I wrote about a subscription I had with a piece of software called GSphere. This program provided a mathematical measure of a portfolio’s diversification, which is a great idea in theory. Certainly, you would want to be very diversified during a bear market. However, the more diversified you are when markets are rising, the weaker your returns will be. For example, this program would score the portfolio from 0% to 100%. A portfolio with a diversification score of 100% would be the most diversified, and of course, the safest. However, a 100% score exists mostly in the classroom. In reality, a score of 55% is considered to be very well diversified.

Conclusion

I still believe diversification is important. Today, I select good-quality funds with strong three- and five-year track records, and it’s important that they don’t move in lock step. If they did, then your diversification score would be very low. Of course, this wouldn’t be a problem during a bull market.
And so the subject of portfolio management continues.

Source: High Quality Money Management?