Does diversification really suck?

Last month I wrote a post ‘busting’ the myth of diversification (and, did a little follow-up segment about it on my ‘live show’ @ AJC Feed).

As expected, I got some ‘for’ and ‘against’ comments … including this comment from Ramit Seth who writes the great personal finance blog I Will Teach You To Be Rich:

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.

Well ….

… Ramit’s very blog is called I Will Teach You To Be Rich … no if’s and but’s about that. So, unless my definition of ‘rich’ is way off …

[AJC: basically, it’s to be able to live the Life of Your Dreams when you Need to live it, and without working … for most people, I’m guessing that’s going to take more than 120% of their current salary and sooner than 65 … if that’s not you, then sign off now]

But, nobody said that you have to “try and beat the market” instead of diversifying 😉 It’s not binary …

What I am saying is this:

a) if you ARE satisfied with ordinary outcomes then don’t stuff around with fancy investments, picking stocks, picking funds, etc. Do the sane thing: go for the ‘guaranteed’ 30 year return of 8% (or, take a ‘gamble’ that you will indeed match the average 30 year return of 11%, if you prefer) via a broad-based, low-cost Index Fund

b) If you ARE NOT satisfied with ordinary outcomes then what choice do you have? Find SOMETHING that you CAN make money out of and DO IT … it could be stocks; business ventures; blogging; real-estate; trading; options; flipping; MLM; working 5 jobs; whatever rubs the skin off your knuckles … [Ramit and I share at least a couple of these ‘interests’ – not together … yet!] …

But, you are going to HAVE to do it (and get BLOODY good and LUCKY at it) … or, go back and read (a)

Remember: the objective isn’t to make money in stocks (or RE, or whatever) … it’s to make money …

… to support Your Lfe’s Dream – whatever that may be; however much it may require!

Can I get any clearer?

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0 thoughts on “Does diversification really suck?

  1. I fully agree with Ramit on the importance of thinking from an entrepreneurial perspective however I do disagree with him in regards to his theory on investments. The math he refers to is most likely the capital asset pricing model and/or modern portfolio theory both of which highlight the advantages of diversifying systematic or market wide risk. These theories in a sense advocate for index funds because of their maximum diversification and low cost structure. The reason that so many mutual funds fail to beat the returns of index funds is because of the similarity of the products and the high mutual fund fees. For example if a mutual fund manager holds 100 stocks it is going to be pretty hard for him to make up for the 2% he is charging you in fees because his basket of stocks is such a large proportion of any index. But for an individual who can concentrate on a few companies with no intention of managing systematic risk but rather focusing on the company specific or idiosyncratic risk (like Warren Buffet does) then they may very will be able to beat the market long term, albeit with significantly more variance.

    Can most people do it, no. But it is no more difficult than starting your own successful company.

  2. The real question is “will diversification achieve the goal to become rich?” the answer is simply “no”, at least not at an age one can enjoy it.
    Thus the choice is simple.

  3. @ Andrew – I would say “similar to the difficulty of starting your own business” because you are right: only a few are destined for financial success – some will do it with business, others with stock / real-estate / or [in rare cases] some combination of all three. The motivations are similar, just the mechanics/mindset varies.

    @ Josh – Thus the choice is indeed simple 🙂

  4. @AJC I agree though I would say that on average success in real estate or a business will result in greater wealth creation than success in the markets. Unless of course you are managing money.

  5. @ Andrew – ‘on average’ I would have to agree with you … but, fortunes have been made in all three.

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