What is diversification worth?

In the investing world, diversification has the feel of holy writ. No one conventional will ever question it.

The reality, however, is that diversification is frequently taken out of context and misunderstood.

For example, many investors are sold on the idea that diversification will prevent their portfolios from tanking when markets go haywire. But, this is seldom the case. Perhaps one’s portfolio goes down 40% instead of 50%, but that’s the best-case scenario at the absolute worst part of a market downturn. How many people are really happy about being momentarily down a little less than the overall market?

I’ve seen presentations that show much less “reduced volatility”–down 10% instead of 11%–pitched as the holy grail, but I’ve never heard a client say, “Boy, am I glad I was diversified,” with such small differentiation.

As with all things in life, there is a cost to diversification: usually lower returns. The sales pitch is that you give up some return in exchange for lower volatility. That’s great, but it must be thoroughly understood that giving up return means less money in retirement. I think many investors would prefer higher volatility and a better retirement, and they should make that choice with a clear idea of what they are choosing. I would happily take 10% more volatility and 10% more income in retirement, and my guess is that I’m not alone.

Diversification is a benefit, but that benefit has limits. A portfolio of 100 stocks should probably be replaced with a low cost index fund. A portfolio that is 80% in your employer’s stock is not very smart. Somewhere in between those two extremes is diversification that works for most people.

Diversification works because it removes the consequences of not being omniscient. No one, not even Warren Buffett, knows the future with precision, so that type of diversification is prudent. 

That does not mean buy a little of everything and the more the merrier. Over-diversification has huge penalties, too, and that comes in the form of lousy returns.

The benefits and drawbacks of diversification seem clearer after the market has tanked and rebounded like it has over the last week and a half. There was little benefit to being investing in one stock versus another, because they almost all went down and back up together. 

The things that did do well, perhaps gold and U.S. Treasuries, either have been or will be terrible investments over 5 to 10 year periods. To gain their benefit in somewhat reduced volatility is to lose future returns that may be worth much more. Perhaps that’s not what everyone wants or needs.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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What is diversification worth?

Focused investing

There are as many different ways to invest as there are stars in the sky.

And, this is why most investors are dumb-founded when trying to pick investments–the choices are limitless.

One of the key problems is that most investment managers are not terribly honest about what they do. They say they do in-depth research, they say they don’t just invest in the market, they promise the moon and stars…

The reality is that the average mutual fund owns 172 stocks. That means their average position size is 0.6%. Even if a 0.6% position doubles, you won’t feel the benefit much.

Added to this, with 172 positions, how on earth does an investment manager do in-depth research on individual companies? Just keeping track of quarterly announcements would utterly over-whelm them. They can’t possibly follow 172 companies in-depth!

The average mutual fund charges their customers around 1% a year to manage money. But, with 172 holdings, it’s almost impossible for them to beat the market after fees. Why not just buy an index fund and get charged 0.2%?

The alternative is to invest with a manager who focuses on only a few investments, let’s say less than 25. Such investors at least have the possibility of beating the market, unlike someone who owns 172 stocks.

If you look at the records of managers who have strongly out-performed the market over the long term, you will almost certainly have found a focused investment manager.

There aren’t that many managers who focus on fewer than 25 investments. Why? Because most invest managers lack the courage of their conviction. As Warren Buffett put it, “wide diversification is only required when investors do not understand what they are doing.”

Added to this, being focused on only 25 investments frequently means higher short-term volatility and requires a lot of patience because short-term under-performance is inevitable.

But, the benefits can be huge. Focused investing can lead to out-performance that can have a huge impact on your long term wealth.

It may take time, it may take patience, it may take a stomach that can handle nerve-wracking ups and downs, but for some investors, it’s well worth the effort.

Besides, what would you rather do with your time? 1) spend several hours picking a manager who knows what they’re doing, or 2) spend the rest of your life diversifying, rebalancing your portfolio, and getting mediocre results anyway?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.