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Diversification

2021-03-16, Michael Thompson

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Diversification

In this article, we discuss pros and cons of diversification. We make the case that broad diversification within equities, while preventing extremely positive returns, is the best option for most people. We discuss some exceptions to this rule. However, we believe that broad diversification among asset classes may be overdone in some cases. We start our discussion with equity diversification, and then discuss asset class diversification.

Equity diversification

There seems to be conflicting information about diversification. Warren Buffett has said diversification “makes very little sense for those who know what they’re doing.” His cohort Charlie Munger says “it’s taught in all the business schools, but they’re wrong.” However, Warren and Charlie’s Berkshire Hathaway has purchased cap-weighted S&P 500 index funds—we’d certainly call that equity diversification. Warren also instructed the trustee of his estate to invest 90% of his money into such index funds. So what gives?

As Howard Marks notes in his 2020 memo, the investing world is different than it was when Warren and Charlie bought companies trading below any reasonable account of their worth. Today, there are thousands of experts and sophisticated computer systems analyzing endless information on virtually every publicly traded company. The prices of “cheap stocks,” if they exist, are quickly bid up to a fairer value. Deals that made Warren and Charlie rich in their younger years are much harder to find. (This is less true for smaller cap stocks—they're less analyzed because not as much money can be invested in them.)

In the old days, someone like Buffett could find a handful of companies that were priced below conservative intrinsic value estimates. In such an environment, there’s little motivation to diversify. Once you found a handful of such companies, why buy hundreds or thousands of other companies that you don’t have time to analyze or understand? That would be silly. Today, however, if you spot such a “deal” in the stock market, there’s a good chance you’ve made a mistake. After all, the thousands of experts and computer systems apparently didn’t find it cheap enough to buy and bid up the price. I’m not saying it’s impossible, only that it’s much more difficult / risky in today’s environment.

Given the difficulty in finding deals today, should we aim for complete equity diversification, using index funds like VT? That's probably a good move for most investors, but there’s a reason why some of us don't allocate all our equity investment to such a fund. While spotting underpriced equities may be too difficult, a number of investors, including myself, believe there are exceptionally overpriced equities. If we can’t select great deals, maybe we can avoid really bad deals. The problem: many (most?) of us have failed in this endeavor. For example, I’m among the many who thought Tesla was wildly overpriced over a year ago. Since then, Tesla shares have returned about 400%! (Thankfully I didn’t short it!) Other seemingly overpriced stocks have had a similar fate. Avoiding these “high flyers” has not been fruitful, at least recently. The question: is this a short-term anomaly or a long-term trend? Only time will tell, but for now I’m avoiding such companies.

There’s another argument against complete equity diversification. A growing percentage of investors want to “put their money where their morals are.” According to a 2019 Morgan Stanley survey, 85% of individual investors were interested in sustainable investing, up from 75% in 2017. Whether it’s supporting climate change initiatives, social causes or other beliefs, some investors are willing to be overweight in some businesses / industries, while completely avoiding others. This admirable behavior brightens my mood every time I think about it. I certainly don’t want to see these people get burned by overinvesting in failing companies or industries. If you’re one of these people, I salute you, but hope you’re aware of the risks. Unless you really know what you’re doing (or want to be a martyr), please realize that investing in just one or a small number of sectors is risky, even if you’re broadly diversified therein. What if a new, safe nuclear technology destroys the demand for solar and wind energy?

When thinking about equities, consider diversification not just among companies, but also among industries and even countries. A political move or currency problem could destroy a particular country’s equity market in short order. Likewise, a disruptive technology could decimate an entire industry quickly. This is the beauty of an index fund like VT—with just one fund you hold a cap-weighted, diversified portfolio including almost all publicly traded companies in all industries and countries around the world.

Asset class diversification

So far we’ve focused on diversification within equities. This is not enough for many of us. Last year (2020) is an example. Some of the most diversified equity portfolios dropped over 30% from mid February to mid March. While that’s better than being caught in specific industries or businesses that lost over 50%, it’s still more than some people could stomach. A study by Magnify Money reported that almost a quarter of investors sold all their stock last March and 42% sold some stock (88% now regret it). Selling after large market drawdowns destroys long-term returns. Diversification among asset classes can soften these blows and prevent some people from selling in such scenarios.

In the March 2020 meltdown, what you'd invested 50% of your savings outside of stocks, say in a treasury bond ETF like TLT? While your equities may have lost about 30% of their value, TLT appreciated by almost 10%. This means that the pure equity portfolio lost $300 for every $1,000 invested, while the 50% bond portfolio lost just $100 for every $1,000! It's sill a loss, but presumably a much more tolerable one.

Table of volatility and returns with various levels of diversification.

There’s a downside to asset class diversification, however. Asset classes other than stocks typically provide lower long-term returns. If you were 100% certain you didn’t need to access your money in the near term, and you knew you could hold on through whatever pandemic, war, etc. may crash the stock market, then you could consider little or no asset class diversification. Of course, none of us are lucky enough to be in that scenario. Even the most risk-tolerant, long-term investors typically have at least 10% of their savings outside of equities. You never know when you or a family member may become sick, unable to work, or some other catastrophe may occur.

Since you probably want to diversify outside of equities, what should you buy? Popular alternative investments include CDs, bonds, real estate, and commodities like gold (and Bitcoin). None of these are likely to outperform equities over the long haul, but each has attractive qualities. Many experts would only recommend CDs, bonds and (maybe) real estate for the average investor. There’s a good reason for this—these are the only assets that have an underlying reason for appreciating. Money lent out via bonds is used to create goods and services that typically allow the borrower to repay the investor, with interest. People are willing to pay to use real estate for housing or commercial purposes, money that can be returned to the owner (after maintenance and other costs). However, commodities like gold and Bitcoin don’t have an underlying reason for appreciating. When you buy one of these assets, you hope someone else will be willing to pay you more for them when you want to sell. This is often referred to as speculating rather than investing. As Bitcoin proponents can quickly point out, this sometimes works amazingly well. However, “real” investments have traditionally been more reliable for long-term returns. If you’re interested, check out what Jack Bogle has to say after 2:00 in the video below.

Asset class diversification does not have to be complicated. A key thing you need to answer beforehand is when you're likely to start accessing the money in your investment—your time horizon. The sooner that is, the more bonds or short-term investments you should hold. A single balanced fund or target-date fund is suitable for most people. All you have to do is buy one of these funds and they will take care of the diversification and rebalancing. With a target-date fund, they'll even shift your asset allocation over time towards safer investments when you expect to access the money. All this can be had for a small expense ratio, typically less than 0.25%. If you want to take control yourself, you could start with example portfolios like Ray Dalio’s “all weather fund.” It’s highly diversified among asset classes including equities, bonds, gold and commodities. As the name indicates, this portfolio aims to weather any storm (or at least most storms) without significant loss of capital. It is not likely to earn high percentile returns over the long run—the price you pay for stability.

Here’s a quick recap of the takeaways.

  • Diversifying among asset classes reduces volatility and risk. If you're risk averse or potentially need to withdraw your investments within a few years consider higher asset class diversification, particularly into bonds.
  • Within equities, broad diversification across countries and industries is probably your best option.

For other views on diversification see articles from Fidelity, Corporate Finance Institute, or Investopedia.

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Comments / Feedback

nysal01 March 19, 2021, 8:40 p.m.
I appreciate the article. How about some additional information about diversification in the bond market?

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