Is Asset Diversification Really Such a Good thing?

Posted by admin on December 3, 2007 in Investment Strategy

The S & P 500 hit market correction status earlier last week which means I am beginning to read a lot of articles on making sure you diversify your portfolio to avoid putting all your eggs in one basket. I am not going to argue with this piece of advice since it is a prudent and conservative approach to take. However, this piece of advice also stumps me for several reasons.

I have a hobby of studying how financially independent people got to where they are (yes, I am a geek). Not what they are doing now but how they got there; its easy to make money when you have a whole bunch of it already. I am always stuck by how many of them are specialized in one particular facet of finance, learned it well and stick to their knitting. Warren Buffet, with the notable expectation of Petro-China, knows the American stock market like the back of his hand; he doesn’t invest in anything outside of stock. Jim Pattison (who’s a bit of a local legend in British Columbia) once said you can only really know one or two countries really well and works primarily at building businesses in Canada in the media space (the Pattison Group owns all those advertising displays in every major city in Canada). Trump does real estate; I never read about Trump buying stock.

Here’s the one thing they do well- they always have a lot of cash on hand (Trump may be the notable expectation since real estate works on leverage) and they control when they use it. Cash allows you to sit out the bad times in your niche or to pick up bargains. You don’t always have to be in action in investing.

It also bothers me that the financial industry tells people to put money in a wide variety of industries and geographies- in mutual funds of course. Most mutual funds underperform the market and, suddenly, I am supposed to trust the financial industry which can’t pick investment products in their backyard properly to pick investments abroad? What knowledge does the industry have about stocks trading in India or Brazil when it can’t pick North American stocks properly? It seems like a huge leap of faith to trust an industry to find far off bargains when it can’t do it domestically. The logic conclusion is to buy an ETF that tracks an industry or geographic area but I really do not trust the transparency or stability of markets in the BRIC region (last time I was in China, the government had to bail out the 5th largest brokerage in the country; imagine the scandal if that happened here? And this was during good times).

Finally, there’s an old military saying- “strong nowhere, weak everywhere.” Most people I know have modest sized RSP/401K’s etc. I don’t why you would take this modest amount of money and put it in 5-8 different industries/geographic areas- you really can’t benefit from any gains properly because your holdings are too small.

Which comes back to me initial point- successful people learn one facet of investing well and stick to it. There’s nothing like expertise and discipline to beat the market.

6 Comments on Is Asset Diversification Really Such a Good thing?

By George on December 3, 2007 at 10:45 am

You’re certainly correct that there are many successful people who do exceptionally well using one aspect of investing. Thing is, there are many more people who do exceptionally poorly. The few that you hear about that have succeeded wildly are examples of survivorship bias (en.wikipedia.org/wiki/Survivorship_bias) and selection bias (http://en.wikipedia.org/wiki/Selection_bias).

You don’t hear many news stories about the many thousands of people who have exclusively poured their money into risky investments and lost their shirts.

Diversification won’t bring you the huge success of a Trump or Buffet, but it’ll generally help you mitigate risk. The goal of diversification is to have assets in classes that don’t correlate well – this maximizes the probable returns while minimizing risk, which is why you hear it preached about so much.

By admin on December 3, 2007 at 2:06 pm

Thanks George. At some point in time, however, isn’t diversification going to harm you? What if you have 10-12 mutual funds spread out among many industries/geographical locations and you have a modest sized portfolio. You end up becoming too scattered and unfocused.

By augustabound on December 3, 2007 at 5:53 pm

I like one of Warren Buffett’s sayings, “Wide diversification is only required when investors do not understand what they are doing”. I’ve also heard it worded, “Diversification is insurance against one’s own ignorance”.
I’ve never adhered to the diversification myth. If you do as financial planners say and re-allocate your assets, your money will be tied into fixed income when the markets turn around and you may very well miss some good gains.
How many planners are saying now to move your money into “safer” investment vehicles? These are the same people who have already lost capital in this short downturn. They will lose again by not being invested on the upturn.
Planners are notoriously late to the game and it’s at the expense of their clients. They still get their commissions though.

By venter on December 4, 2007 at 6:28 pm

As a financial advisor i’d like to respond to augustabound. I for one do not advocate moving to “safer” investments after a drop in value, that just crystallizes a loss. I prefer to put my clients into a balanced portfolio which is diversified geographically and by investment style and has a bond component that reflects the clients risk level. I then suggest we leave it alone until their personal situation requires we change the asset allocation.

By augustabound on December 5, 2007 at 4:51 pm

Fair enough. I shouldn’t have generalized like that, sorry.
I just get frustrated when I hear or read about planners suggesting their clients move assets from equities to fixed income because of a perceived downturn. Nobody can market time yet people try everyday. The “bottom” has been called by professionals for the last 2 years, some people lost out on some good returns because of it.
I might be a bit biased since I don’t see stocks as being risky as long as you do your own due diligence. I’d rather hold blue chip, dividend payers knowing the highs will usually outweigh the lows. So many people who don’t know any better think that all stocks are risky not realizing that equity mutual funds are comprised primarily of stocks. Before I educated myself I though that too though.

By Canadian Capitalist on December 5, 2007 at 6:59 pm

There are many interesting observations in this post:

1. I agree with George that there is a lot of survivorship bias in the list of focused rich people. Diversification guarantees that you won’t succeed wildly but it does offer a lot of protection against failing spectacularly.

2. Beating the market is extremely tough. I’m currently reading one of Larry Swedroe’s books and he points out that fund managers do not beat the index even in supposedly “inefficient” markets like small caps and emerging markets. There is logic to this finding: after all, as a group we are the market and we can’t possibly all be above average.

3. I agree with you that I don’t get the wild enthusiasm for exotic markets where even basic things like property rights are subject to the whims of the government.