The Myth of Diversification

Important Announcement: Applications for my 7 Millionaires … In Training! ‘grand experiment’ CLOSE TONIGHT (June 2) at Midnight CST !!! This is your last chance to throw your hat in the ring …

I have been just itching to write this post … it falls straight into the category of ‘uncommon wisdom’ and will probably be jumped on by every Personal Finance author and self-appointed ‘finance guru’ out there.

All I can say is …

… bring it on, baby!

If you’ve read my posts on the only three ways to invest in stocks and the follow-up post that quoted some of Warren Buffet’s views on Index Funds vs direct stock investments, you’ll have some idea where this is heading.

But, if you’re just reading 7million7years for the first time, here it is in a nutshell:

1. Diversification is only suitable as a mid-term saving strategy – it automatically limits you to mediocre returns: The Market – Costs = All You Get … period!

Now, saving money this way, and compounding over time (a loooooonnnnnngggggg time) will put you way ahead of the typical American Spend-All-You-Earn-Then-Some Consumer ….

Just don’t confuse it with investing or wealth-building: it simply can’t, won’t, will never make you rich … nor will it make you wealthy …. nor will it even make you well-off ….

… because as long as you run, the dog of inflation is nipping at your heels!

However, it WILL stop you from being poor, broke and you may even be able to retire before 70, on the equivalent of $30k or $40k a year – not in today’s dollars, but in the inflation-ravaged dollars of the day that you retire!

But, if that’s all you need, then relax, that’s all that you need to do 🙂 But, if you need more then …

2. Concentration puts all of your eggs into one (well, a very few) baskets – it automatically gets you above average returns … if you get it right!

Investing implies taking some risk … it means choosing a vehicle (stocks, business, real-estate) … it means selecting one or a very few, well-chosen targets … it means putting your all into those well-selected targets and actively managing them for above-average market returns … until you get close to retirement.

Now, I could wax lyrical on this subject all day, every day … but, why trust me when you hardly know me and you can simply go to a source that everybody knows and can respect … Warren Buffet, who says:

I have 2 views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.

If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice. “Lebron James” analogy. If you have Lebron James on your team, don’t take him out of the game just to make room for someone else. If you have a harem of 40 women, you never really get to know any of them well.

Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. Later in 1998, LTCM was in trouble. With the spread between the on-the-run versus off-the-run 30 year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up.

Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position. We’ve suffered quotational loss, 50% movements. That’s why you should never borrow money. We don’t want to get into situations where anyone can pull the rug out from under our feet.

In stocks, it’s the only place where when things go on sale, people get unhappy. If I like a business, then it makes sense to buy more at 20 than at 30. If McDonalds reduces the price of hamburgers, I think it’s great. [W. E. B. 2/15/08 ]

So Warren Buffett seems to be suggesting that the average investor should be diversifying … not true. He is saying that unless you educate yourself, you should be ‘saving’ not ‘investing’ … but, here is what the difference between the two strategies means to you financially:

 i) Warren Buffet-style Portfolio Concentrationhas produced 21% returns compounded annually since warren Buffett took the reins of Berkshire-Hathaway 44 years ago. This is how he became the world’s richest man, and created many other multi-millionaires in his wake.

ii) Common Wisdom Portfolio Diversificationas measured by an index such as the Dow Jones Industrial Average (DJIA) averages out to just 5.3% compounded annually, even though the DJIA appeared to “surge” from 66 to 11,497 during the 20th century.

When you subtract 4% average inflation from each of these sets of returns, which do you think has ANY CHANCE of making you rich? 

But, it’s true that it is far better to be earning $30k – $40k (albeit in ‘future dollars’) in retirement than being flat-broke … so you need to build a safety net before you take on the additional risk that concentration implies.

Here’s how:

1. Create two buckets of money: your long-term savings, and your risk-capital.

You should first create your long-term savings bucket, as your fall-back … this means, max’ing your 401k; being consumer-debt-free; buying your own home and building up sufficient equity to satisfy the 20% Rule; and holding some money in reserve (this could be a 3 – 6 month emergency fund, or extra equity in your home that you are prepared to release in an emergency).

2. Maintain your long-term savings with the first 10% of your current gross salary, but using excess savings (i.e. any additional money no longer required to pay off debt now that you are debt-free); 50% of future pay-rises or other ‘found money’;  50% of any second income (e.g. from a part-time business) all to fund your risk-capital account.

3. Educate yourself on the investments that you will specialize in … then do your homework on the specific investments that you want to make and seek professional advice before stepping (not jumping) in.

4. If you fail … fall back to Step 2. then try and learn from your mistakes … but do try again/smarter.

Which path will you take?

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34 thoughts on “The Myth of Diversification

  1. Most people never get past the stage of establishing their safety net, but many go ahead and try leaping into the ‘concentration’ stage anyhow (this could be called the “putting the cart before the horse, all your eggs in one basket, and then whipping the horse” strategy).

    Even when people do get their safety net in place and are in a position to afford to try making a few investments with their “at risk” capital, most will do poorly (even if they “try, try, again”). After all, the most professional investment fund managers perform worse(after deducting fees) than the relevant index in most years. And individual investors (as a group) tend to perform even worse than professional fund managers. There are very, very few Warren Buffets in the world – in fact, I can think of only one 😉

  2. 1. Create two buckets of money: your long-term savings, and your risk-capital.

    Now this is advice I like 🙂

    I have a problem with PF Bloggers like Ramit Sethi – who say “you can’t beat the market in investing” but advocate becoming an entrepreneur. What makes him or anyone else think they can beat the market as an entrepreneur (when most small businesses fail). Some people can succeed as entrepreneurs, if they know what they’re doing and have a bit of luck probably too and the same goes for investing.

    Berkshire today, is anything but concentrated except on insurance. Here they really know what they’re doing. The investments including portfolio companies are very diversified. So really, they’re following your philosophy here :0)

    Oh and Buffett borrowed against his BRK stock to invest for himself and get some income as he won’t pay himself a decent salary or a dividend. So he didn’t keep to the don’t borrow money to invest thing himself.

  3. personally, I’m a long way from thinking about any sort of serious investing. Currently I’m doing a lot of saving, retirement and otherwise, as I plan for the future. So I would be a long way from leaving step 1.

  4. WOW! AJ!!! I am so glad to see you put this in writing – I’ve been spouting this out ever since I finally took some financial courses. Diversification makes your investments “safer” perhaps, but basically dilutes the great earnings you’re getting with one investment by the one you bought to offset its potential losses. And the word “offset” should be the key – they are offsetting each other’s gains as well!!! Glad to hear you think like me in this regard, and/or that I think like you. Besides which, most conglomerates are already diversified, so buying one of them pretty much diversifies the risk already (they are typically low-risk investments to start with). Since I am rebuilding a retirement, I have gone with higher risks in the market place, but low risks when applying some brain power to the investments. I made about 30% last year in my 401K and am glad to see it getting back on track this year finally (up about 10% last I checked, tho it was down for at least the first 3 months).


  5. Diversification is still investing, it just might not be as smart. I’m more of a index fund guy. I know it doesn’t have as much potential as choosing just a few stocks but I am willing to accept this trade off.

  6. It sounded to me that it’s going to take me, who have only been working for 3 years, more more years to go to step 2. Does that mean i should just save and forget about investing for now? until i have the money to own a house?

  7. Wow … no ‘flames’ yet?! You lot are a bunch of pussies 😛 Seriously:

    @ Enough Wealth – I am just offering sensible advice (put in place a ‘safety net’) … but, most people who will end up being rich will ignore this step; it’s in their makeup to do so. Of course, 9 out of 10 (99 out of 100?) of those trying …. fail.

    @ Moom – I put ‘active investing’ in the same bucket as entrepreneurship; they are both ‘businesses’ and shoudl be treated as such. Two buckets is better than one; sadly most just choose one OR the other …

    @ Q – … who represents Bucket # 1; which is WAY better than NO BUCKETS at all!

    @ Di – … who represents dipping a toe in Bucket # 2; just be careful that you actually know what you are doing!? Are you beating the market long-term or not … just a question 🙂

    @ David – You write my posts from now on! What I said in 700+ words, you just said in 50. Sounds like you know the trade-offs and you have made the choice that’s right FOR YOU. Nice.

    @ klughing – see what I said to Moom, but see a financial advisor before you start.

  8. @ Moom – the diversification that Warren Buffet has within Berkshire Hathaway is entirely different than the diversification one gets by holding an index fund.

    The idea of an index is to limit yourself to only the risk of the overall market (systematic risk) by holding as broad an index as possible and thus diversifying away the risk of any individual company. This is opposed to this risk of holding many individual companies (idiosyncratic risk) based on a bottom up investment philosophy. Although Warren Buffet holds companies in many industries he is not actively trying to eliminate his idiosyncratic risk.

    Even though both are diversified the investment philosophies are entirely different.

    For the record moom’s comment didn’t imply that the two were the same I was just responding in general to a common misnomer of diversification.

  9. @ Andrew – You calling Warren Buffett an IDIOsyncraTic? Gutsy 😛

    I agree: Warren Buffett has a large portfolio because he buys companies and holds them ‘for ever’. As they generate excess cash he ‘needs’ to buy more companies … so he does.

    WB’s diversification is the ‘unintended side effect’ of his growing investment business.

  10. Now that’s what I’m talking about! Finally a blogger that doesn’t promote diversification.

    I wrote a few articles like this and took a lot of heat. This is not the happy safe path that everyone wants to read about.

    I wrote an article just last week titled “Which is Better – Diversify or Focus Investments”

    Your are right on the money. If you really want to get rich, you have put in your time and learn about what you are investing in. When you have calculated the risk in your favor, put all (or most) of you money in. If you fail (which is always possible) try, try, try again. Only this time, you are much more knowledgable and less likely to fail.

  11. I agree that the diversification makes your returns moderate even if you have been mostly right. This is time of specialisation and one should be concentrating on companies of his and study and resort to shor-selling as much for long buying. Further there is no scope in looking for companies with long term prospective , in todays times the three month is long term because so much can change now over three that used to change over years. You are invited to visit for the study of Indian markets and stocks.

  12. @ Curt – I agree; it’s the SEEMINGLY “happy safe path” – that is, until you reach retirement age and realize that you still require Social Security (IF it still exists!) handouts and belt-tightening in order to make ‘retirement’ ends meet.

    Your future starts RIGHT now: in your 20’s. What will it be? Diversify and forget, or … ?

    @ Krsnakhandelwal – Thanks; nice to have a reader from India … normally I delete links, but I know of no other ready source for Indian stocks than yours.

    BTW: I am not advocating ‘concentrate and gamble’ … I am not advocating ‘diversify and hold’, either: concentrate holdings and look for the long term, whether stocks, real-estate or businesses (although, this latter one can be sold if the multiple is stellar).

  13. I agree whole-heartedly with this post. Diversification works both ways. Sure it moderates loss, but it also moderates gains. If you’re risk adverse diversify to your heart’s content but if you want to really put your money to work, do the research and pick the best baskets.

    @Enough Wealth – Fund managers lose because they are heavily restricted. It takes an enormous amount of effort to pick a handful of quality stocks, I’m not sure I would want to be forced to find twenty or more. They also run into a size restriction that hinders investment in a fairly sizable portion of the market. In short, the deck is stacked against them so it is reasonable that they under perform. As a private investor, given the time, you should be able to outperform them.

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  15. No, I’m with Tap Water – I am opting for number 2, even borrowing, so that I can create #1, plus mixing #1 with #2…or am I mixing the buckets too much ? I’m okay with the mix…but agree, if you don’t know what you’re doing – stick to an index fund which has stocks and industries you understand (dogs of the Dow comes to mind as we all typically recognize their names).

    @AJ – define long-term 🙂

  16. @ Di – That’s a great question; the ‘pat’ answer is MINIMUM 10 years. The real answer is: depends why you need to know? Good subject for a post – watch for it next month! 🙂

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  18. It’s good advice… if you’re lucky enough to pick the right concentrations. The vast majority of investors won’t. They will not beat the market, nor will they be as famous as Warren Buffett so as others can learn from their example as we learn from Buffett’s.

    It’s great advice if you have the skill and inclination to put endless hours into research and analysis. Pay someone else to manage your funds and (a) they won’t care about it as much as you and will not be motivated to work completely in your interest at all times — let’s face it, they have bigger fish to fry — and (b) the fees they charge will eat into the returns and you won’t beat the indices after fees and taxes anyway.

    It’s excellent advice… for the few who when looking back will have succeeded with this strategy. Tell the average investor to manage his own funds and you’re setting up a great disaster story (or, less likely, a great luck story).

  19. @ Flexo – I’m on record as saying that the ‘average investor’ should diversify into low cost index funds … but, who thinks they are ‘average’ these days?

    IF you have a ‘big dream’ and NEED ‘big results’ you are going to have to take ‘big/concentrated action’ … but, I don’t necessarily think that HAS to be in stocks: RE / business / corporate ‘high flyer’ / top professional are all reasonable candidates for yuor undivided attention, too (the latter two, when combined with a concentrated investing strategy).

  20. People love to talk about beating the market when, in reality, they rarely even get close to matching the market. Instead of doing the mundane work like paying off debt, maxing out retirement options, and properly diversifying, they go after the next best thing.

    And even if they focused *only* on beating the market, odds are they still couldn’t. In fact, fewer than 15% of mutual funds fail to beat the market over time, with managers that focus on investment full time.

    David Swensen is a great voice to read in this argument.

    Also, here’s another tidbit: In a 1996 study of hundreds of over 200 market-timing newsletters (the ones that claim they can help you beat the market), two researchers named Graham and Harvey put their findings delicately: “We find that the newsletters fail to offer advice consistent with market timing.” Hilariously, at the end of the 12.5-year period they studied, 94.5 percent of the newsletters had gone out of business.

    Saying that “you can pick better funds than average” is exceedingly difficult. And saying that “index funds” are boring is a great excuse to seek out sexy investments without taking care of the bottom-line concerns first. Chances are, the people who say this aren’t even getting index-level returns.

    “Moom” said that I encourage people to be entrepreneurs when it’s not clear that I’ll be successful. A good point, but I advocate people to think entrepreneurially, not to all be entrepreneurs. There’s a big difference.

    The final point — you should read the research on how diversification can reduce your risk and actually increase your returns. This is not a touchy-feely argument about how diversification makes you “feel.” Read the investment literature and the math behind it. It works.

  21. @ Ramit – Nice to have you drop in! My responses are wide and varied, so I will write a follow up post, soon … stay tuned 🙂

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  23. I love this post. I think everyone should take some risk

    I do the index fund thing when it comes to retirement, I also own a house and have cash savings on the side

    Then I have my “play money” – risk-capital

    As long as the family is taken care of first- (bills paid, savings and retirement), then it’s my time to play!!!

  24. @ MoneyMonk – That’s it … I’m closing down my blog and just putting in an auto-forward to YOURS 🙂 But, you have put it in a nutshell …. although, if you do the 7million7year ‘thing’ you won’t need your ‘index fund thing’ TO RETIRE … maybe, it’ll become a nice tidy (albeit small’ish) sum just to give to charity?

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