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Diversification Part II
*Please note that this article focuses on diversification within a stock portfolio, however the concepts apply to one’s overall portfolio, as well. An investor’s broad portfolio should also diversify among different asset classes (stocks, bonds, real estate, etc.), styles (large-cap, growth, short-term, etc.), and countries. We advise investors to consult a financial professional to develop a customized and detailed asset allocation plan.
Welcome to the second of our articles on diversification. For those of you who missed the first part, you can read it here, however a short recap is in order. In the first part, we went over the basics of risk, how it is defined, how to make sense of correlation coefficients, and finally, the benefits of diversifying one’s portfolio. However, not everyone is convinced that this is, indeed, the best strategy to employ. While this is not meant to be an exhaustive list, we will discuss a few of the most popular counterarguments to diversification.
First, let’s start with the two alternatives: a concentrated portfolio or no portfolio (all in cash – or under the mattress). According to Warren Buffett, “wide diversification is only required when investors do not understand what they are doing.” While it is very possible to outperform the broader market averages over long periods of time holding only a few assets (just look at Mr. Buffett’s lifetime performance record), not everyone has the superior skill set that Mr. Buffett possesses. For the rest of us, diversification seems to be our best strategy.
Holding all of one’s assets in cash, or short-term Treasury bills, may also not be the wisest strategy. While you won’t be exposed to market gyrations, inflation risk will be your number one enemy. The price of goods is almost always increasing and if a person’s earning power does not increase at least equally with inflation, then he/she is effectively losing money. Moreover, even in turbulent markets, cash or cash-like securities may still underperform other assets. Indeed, back in March, 2009, William J. Bernstein, a financial theorist, mused that if a person could go back in time to 1998 knowing that the financial markets will suffer through two serious recessions in the next decade, an investor might be tempted to put all of his/her money in Treasury bills. However, he later pointed out, that despite the tumultuous markets, a well-diversified stock portfolio still outperformed T-Bills over that woeful decade.
With the alternatives out of the way, let’s look at some counterarguments. Investment diversification guarantees that you will not achieve long-term superior returns. By spreading money across different investments, it is almost impossible for all of these assets to dramatically rise at the same time. As a result, it is way more likely that this portfolio will underperform in bull markets, but outperform in bear markets. And, over the long-term, these consistent middling returns should be enough for most people. (After all, doesn’t “slow and steady” win the race?)
On a related note, proponents of diversification may argue that there are only a handful of suitable investments at any given time, and by diversifying among many assets, a person will dilute the quality of their holdings. However, this may best be viewed in the context of a sports analogy. Consider the 1980 winter Olympics held at Lake Placid, NY. At the time, the Soviets were widely considered the favorites to win the hockey gold medal. The team had won the previous four gold medals and had, at the time, some of the world’s best players. Moreover, some players on the team have been together for decades. However, at the end of the day, the U.S. squad came away with the gold, even though it consisted of a bunch of college kids who only had played together for several months leading up to the event. As in sports, a portfolio (team) does not always need to consist of the best investments (players), but the right ones. The portfolio manager (coach) has to do his/her research to determine which part each investment will play in the portfolio, and how it will react with the other securities for the betterment of the overall portfolio.
Another point pertains to the amount of securities that a person owns. By holding many stocks, it becomes costly not only in trading fees, but also in the time required to monitor these investments. However, a case can be made that this depends on the investor. The cost part may or may not be true, depending on which brokerage platform an investor uses. There are plenty of low-cost brokerage sites a person can use to minimize costs. In terms of time spent, it depends on how much a person would like to learn about a particular company. If one holds only five investments versus 15, he/she better make sure he/she knows a lot about those five companies; with 15 companies, someone can get away with knowing much less. If one of the 15 turns out to be a bad investment, it is not that big of a deal (only about 7% of the portfolio). Conversely, if one out of five turns sour, it is a much larger percentage of the portfolio (20%). Overall, it’s debatable how much time should be spent on either strategy.
The argument that we believe holds the most weight is the case of the correlation coefficient. There are two main arguments here. First, is that in times of economic distress, when diversification is really meant to shine, correlations among securities tend to become more positive. While this is true, market distress typically does not last for a very long time. A concentrated portfolio could very well outperform a concentrated one over the short haul, but diversification is a long-term strategy.
Second, is that the correlation coefficient is a backward looking metric; meaning that even though something may have been true in the past, it is not guaranteed to work in the future. (We are all familiar with the old investment maxim, “past performance does not guarantee future results.”) The argument goes that in order to wisely invest for the future, people must consider the actual drivers behind each security. Once this is done, they must make decisions based on their interpretation of these drivers and their outlook going forward. Needless to say, this is no simple feat and not one that will come naturally to the casual investor.
Now that the main points of both sides of the argument are presented, what do you think? To us, the decision to diversify or not to diversify is pretty simple. We believe a well-diversified portfolio with ten to 15 equities across the major sectors of the economy is the best option for most investors.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.