The Wisdom of Diversified Portfolios in an Age of SMB Uncertainty

Five months into 2019, the bumper crop of great economic news is enough to burst the walls of a grain silo. Not long after five consecutive quarters of interest rate hikes, the Federal Reserve has projected none for the rest of 2019: a course it underscored on May 1 following its policy meeting.

A record 10-year economic expansion continues to roll. Unemployment remains at a rock bottom 3.8 percent as of March, according to the Bureau of Labor Statistics. Consumer confidence is at an all-time high, too, even as the latest GDP report from the Bureau of Economic Analysis showed a 3.2 percent annual growth rate in the first quarter, significantly stronger than analysts expected.

Yet uncertainty for small and midsize businesses (SMB) demands that financial institutions pay close attention. The reasons for caution are many, from the continued consequences of the trade war with China to the possibility of a recession in 2020 that some observers see. In fact, the CNBC Small Business Confidence index dipped from the 62 to 59, between the third and fourth quarters of 2018, a surprising five percent drop.

Meanwhile, we’re late in the credit cycle for real estate, even as many institutions maintain a heavy commitment to the commercial and industrial (C&I) sector, which as a percentage of overall loan composition has shot up from 19.4 percent in 2013 to 21.6 percent in mid-2018, according to the Federal Reserve.

We may have forgotten what it feels like, but the U.S. economy runs in cycles, high and low tides. The bottom line is that to ensure profitability, banks must diversify their portfolios.

Ever since economist Harry Markowitz won a Nobel Prize for developing modern portfolio theory in 1952, balance and diversification have been watchwords of wisdom. Markowitz himself said as much, and today has more than 60 years of empirical and mathematical proof to back it up.

Consider these three reasons to embrace diversification as a smart strategy ahead of tough times:

Reduced Risk

The Fed's Division of Banking Supervision and Regulation has confirmed a significant correlation between loan portfolio concentrations and bank failures. Imagine what the increasing traffic in C&I loans, for example, might mean if that market experiences significant disruption.

Say that you've just upped your stake in C&I to 25 percent or more of your portfolio. Now what? Step back to review where your money comes in (depositors, debt holders and equity holders) and where it is ultimately allocated (stocks, bonds, currencies, commodities, loans, mortgages, mutual and hedge funds). A diversified portfolio enhances asset quality, performance and resilience, while cutting undue risk and the need for costly external financing.

Good Performance in Not-So-Good Markets

Yes, banks will have concentrated areas of interest. But the wise course is as simple as the proverbial "don't put your eggs in one basket." A variety of loan products from different asset classes, divided in an optimal way, will calm the seas for banks in the midst of a greater economic storm. The higher the number of non-correlated asset classes in a portfolio, the lower the risk of big financial losses when market events head south.

Staying in one asset category, by comparison, is a setup for unnecessary risk; likewise, concentrating on a single economic sector can spell big trouble if it starts to sink (such as with energy in recent years).

Expanded Market Share

Some markets are saturated, and the one-trick portfolio often errs to the side of densely populated industry sectors. A diversified portfolio, by contrast, opens a gateway to discovering (or rediscovering) underserved areas, such as the secondary market for manufactured home loans.

The Urban Institute, a Washington D.C.-based think tank, cited new evidence in September that "manufactured homes appreciate as well as site-built homes." In fact, the line graphs on the Home Price Index for manufactured and traditional homes run virtually identical between 1995 and mid-2017. Many banks serve the latter. Who's serving the former—and do loans in that marketplace have a place in your portfolio?

Portfolio Pros: Good History Repeats Itself

That Harry Markowitz had the vision to define a strategy that has stood the test of generations, and remains solid in an age of artificial intelligence and powerhouse computers, should reassure even the most skeptical banker. But if by some chance that’s not the case, note that Markowitz himself supposed that portfolio diversification predated his paper by a good three centuries, as quoted in “The Merchant of Venice: “My ventures are not in one bottom trusted, nor to one place.”

Clearly,” an admiring Markowitz wrote in 1999, “Shakespeare not only knew about diversification but, at an intuitive level, understood covariance.”

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