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Wall Street Steward Blog

Diversification's Dirty Little Secret

One of the cornerstones of managing money is a concept called “diversification.”  Although you can read the textbook definition of the term, I prefer to use real world language to explain this concept:

Diversification is spreading your money around in many different types of investments in an effort to reduce risk. 

Entire books have been written about this topic, so obviously there are intricate details that I dare not mention here, lest your head end up resting in a pool of “deep sleep drool” on your desktop.  Suffice to say that it is a risk management technique and it goes sort of like this:

“Invest in A, B, C, D, and E because I have no way of knowing which one will perform the best over the next 5-10 years.  When A and B are doing poorly, then D and E should pick up the slack.  Then, when D and E struggle, A and B will recover and offset them.  Why is C there?  Oh, C is there in case everything crashes….C is our contingency plan.”

Diversification is real.  It works.  I believe in it.  It is the right thing to do.  I use it.

However, the strategy is NOT deep breath PERFECT.  Most would agree that this concept is so integral to our industry that to even challenge it slightly could brand me as an outcast.  So, I have a choice to make.


  1. Write about the positives and how “every investor should do it to reduce risk?” or…

  2. Throw caution to the wind, hit the status quo in the mouth, and tell you everything that is wrong with diversification.

 

Hmmm, let’s see…choice 1…thousands of articles about this…tried and true…every advisor will preach it…..Y-A-W-N.  I am BORED.  I would rather watch paint dry.

Prosecutor or Defense Attorney?  Good guy or bad guy?  Which side of the argument…

{Right hook connects with Status Quo’s jaw}

Here are the negatives of diversification:

DOESN’T ALWAYS WORK
In the second paragraph of this blog entry, I defined the “D word” and part of the definition was bolded.  IN…..AN…..EFFORT to reduce risk.  It doesn’t always work.  Sometimes virtually everything goes down and no matter how diversified your portfolio is, losses will not be prevented.  It is NOT fool-proof.  One cannot eliminate risk, but can only try to reduce risk.  During those “perfect storms” (like 2008), most asset classes become highly correlated and they all correct together.  In times like that, your portfolio will decline unless your portfolio involves a bag of cash, your back yard, and a shovel. 

REPORT CARD MENTALITY
If your child brings home a report card that reads A, A, A, B, and D, which grade would you discuss with them first?  “Oh Johnny, I am so proud of the A’s, but what in the #@$* happened with the D?”  Johnny still had a 3.2 GPA in aggregate, but had some issues with that one class.  Diversification can create this.  Consider the following portfolio:

Fund Gardner:  +21% return in 2010 (A)   
Fund Archie:     +19% return in 2010 (A)    
Fund Catoe:       +23% return in 2010 (A)
Fund Miller:      +12% return in 2010 (B)
Fund Roche:      -10% return in 2010 (D)

Assuming each fund is weighted equally (20% in each one), this portfolio would have produced a 13% gain in 2010, which beat the S&P 500.  You are above average.  BUT, Johnny had a 3.2 GPA and that is above average too, but don’t you still want to talk about his D?

Imagine if I told you to sell ½ of your positions in Gardner and Catoe, and put the proceeds into Roche, would that be difficult for you to do?  If not, you are either not human or you are Warren Buffett.  This advice would be the equivalent of selling 2 of the A’s on the report card and buying the D.  This is counter intuitive and VERY FEW investors can bring themselves to do it, which can be the reason that diversification will not work for them. 

If they sell the Roche fund instead of buying more, it throws off the entire portfolio and once the other funds correct, there is nothing to offset the losses.  

WEALTH PRESERVATION vs. WEALTH CREATION
Diversification is a risk management tool, which means by definition it is a strategy aimed at preserving wealth rather than creating wealth.  There are some truly wealthy people in the world got that way by taking some big risks and by CONCENTRATING their investments.  Don’t believe me?  Good, I like a challenge, so let’s consider the top 3 richest Americans.

Bill Gates:  Net Worth estimated at $53 Billion
Warren Buffett:  Net Worth estimated at $47 Billion
Larry Ellison:  Net Worth estimated at $28 Billion 

What do these three have in common besides more money than the GDP of the Bahamas?  They all are CEOs of large corporations (Microsoft, Berkshire Hathaway, and Oracle), and all still have huge positions in their company’s stock.  These are the estimates:

Gates:  725 million shares of MSFT (approx $20 Billion)*
Buffett:  350,000 shares of BRKA and 1,501,532 shares of BRKB (approx $42 Billion)*
Ellison:  1,106,224,580 shares of ORCL (approx $35 Billion)
**

These are numbers that most of us cannot comprehend, but we all can understand percentages.  Gates has about 38% of his net worth in Microsoft stock, whereas Buffett has almost 90% of his net worth in Berkshire stock.  These men did not get this wealthy by buying the Russell 3000 index and diversifying.  They are not very diversified.  Buffett’s situation is unique because Berkshire is in essence a large fund of companies, but the largest 3 holdings make up over 55% of the company….still concentrated.

Of course, by concentrating your holdings, you ratchet up the risk substantially, but the potential reward is also high.  So, if your neighbor has 50% of her net worth invested in her company stock, she is taking a huge risk but is also attempting to BUILD wealth.  If her goal was to just preserve what she had, she could try diversification.  

I AM STILL A BELIEVER
Please do not read this article and jump to the conclusion that I am not a proponent of diversification.  Nothing could be farther from the truth as I use the tactic every day and will continue to recommend it.  However, in the spirit of full disclosure, I am here to say that diversification also has its limitations.  I did not cover all of them in this entry, but these should be enough to make the District Attorney nervous about which way the jury is leaning.

source:  The Microsoft Blog at Seattle PI (linked)
*
source:  SEC filings (linked)
***source:  SEC filings (linked)

The examples provided in this article are hypothetical and are not representative of any specific situation.  Your results will vary.  The hypothetical rates of return do not reflect the deduction of fees and charges inherent to investing.  There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.  Diversification does not ensure against market risk.