...and other bad excuses for not diversifying your assets
Over the past few months I’ve discussed the benefits of a diversified portfolio, but there are several reasons why diversification has been criticized as an inferior investment strategy. Let’s go through several chief complaints:
You’ll Never Hit a Home Run
My favorite sport is baseball and like many people my favorite part is watching a slugger hit a ball out of the park. But have you noticed that home run hitters also tend to strike out a lot? By swinging for the fences they end up walking to the dugout more often than jogging around the bases, only to come back next time with the same strategy. It works the same way in investing, except for one major difference—when you strikeout you don’t get a second chance at retirement. You should think of your role in investing as if you are the leadoff hitter on a baseball team; you’re trying to get on base by hitting singles and doubles. In the game of investing, consistency wins. Diversification is all about giving up the small and highly unlikely chance of outperforming the market in exchange for reducing the much higher chance of dramatically underperforming the market.
Diversification is Boring
There’s a show on CNBC called FastMoney which mimics an ESPN sports show. The expert analysts sit on a desk and analyze the day’s market at Mach speed. Meanwhile a sidebar ticker shows the price of the undiversified NASDAQ 100 index to the one-hundredth of a second. “Google got clobbered today because it missed its earnings by a penny!” proclaims one guru. All gurus at once: “Apple rises on Steve Jobs return,” “Citi shares fall amid government takeover,” “Hormel surges on record Spam production,” and on and on it goes. This is all very exciting, but consider that these analysts are telling you what has already happened but nothing about what is going to happen. It’s entertainment and is meant to grab your attention and make you feel like you’re in control. If you think of the market as the collective wisdom of millions of people, what makes you think that only you are right and everyone else is wrong? That’s not a bet I would be willing to make. The only thing “fast” about this money is how fast you’ll lose it. If you want entertainment, go to Vegas; if you want a successful investment experience, stick with diversification.
No Respect in the Doctor’s Lounge
You leave your busy shift for a minute to grab some lunch and look at the ticker symbols whizzing by on the bottom of the flat screen TV. Inevitably the beaming surgeon next to you just can’t wait to tell you about his latest stock pick. “I really hit a grand slam on Pfizer: I’m up 30% in the past few weeks. How about you?” “I don’t own any individual stocks,” you respond, embarrassed. The surgeon thinks, “What a chump!” as he rushes to the OR. With diversification you’ll never get bragging rights with your friends or at cocktail parties. But diversification isn’t a competition between you and the next doc. It’s about meeting your financial goals, not someone else’s, and doing so in the most efficient way possible. So the next time this happens remember that most people don’t use an evidence-based approach to investing. Who’s the chump now?
Diversification is Dead
This is perhaps the most potent allegation against diversification after the market slaughter of 2008. After all if diversification is supposed to prevent you from owning only the worst performing asset class so that you increase returns and reduce risk, it sure didn’t help in 2008 when you needed it the most. As the chart above shows, almost every asset class went to the clearance rack. Does this prove that diversification doesn’t work? While diversification tends to mitigate extreme losses it does not guarantee against losses nor does it guarantee against large losses during every time period. If it did, then there would be no risk and hence no higher expected return from stocks. Further, this is not the first time in the past century that multiple asset classes had negative returns in the same year. The correct way to think about diversification is that it will never take away the risk of being in the market. We should expect that there will be time periods where market risk is extremely high but we just don’t know when those time periods will occur. If you can’t handle this type of risk, then dial down your exposure to stocks—permanently.
Setu Mazumdar MD practices EM in Atlanta, GA and has passed the CFP® Certification Examination.