By
Chuck Carnevale
:
There's an old cliché about real estate investing that states
that the three cardinal rules are: location- location- location.
Clever pundits have borrowed upon this refrain and glibly state
that the three most important or cardinal rules of investing are:
diversify- diversify- diversify. However, careful analysis will
reveal that diversification is a multifaceted concept that has
different meanings, benefits and even risks depending on how it's
used and what its ultimate purpose is. Therefore, my goal is to
examine this ubiquitous investing concept from various angles and
perspectives.
Diversification Within or Across
When thinking about diversification there are at least two broad
categories to contemplate. The first I would call broad
diversification or spreading the risk across numerous asset
classes. To me, this is analogous to the throw as much mud on the
wall as you can while hoping that some will stick idea. Many
experts advocate the diversifying broadly approach. However, to my
way of thinking, the idea of diversifying just for diversification
sake is not always a sound idea. In other words, I would never
advocate putting money into an investment that prudent analysis
indicated was a bad place to invest just for the sake of so-called
diversification.
For example, and I know it is going to generate strong
disagreement, I think gold is an asset class at a bubble valuation
that should be currently avoided. Personally, I sold mine last
summer. The following graph courtesy of Goldprice.org says it all.
Gold was an attractive investment in the late 1990's to early
2000's, but it is clearly at extremely high levels now. Therefore,
I would suggest taking some (or even all) profits. As I have
written before, I feel that fixed income (bonds, etc.) is also at
an extreme, and therefore, I temporarily also favor avoiding this
asset class. I feel that asset classes should only be used for
diversification when they are prudent and sound. To force money
into a dangerous investment solely for an artificial commitment to
diversification makes no sense to me.
Gold, a Twenty year History (Courtesy of
Goldprice.org)
(Click to enlarge)
Furthermore, I tend to have a much narrower view of asset
classes than many of my peers. Regarding liquid assets I see only
what I call owner-ship or loaner-ship. Where owner-ship represents
equity with the investor positioning themselves as an
owner/shareholder, and loaner-ship where the investor loans their
money at interest. Others might call this equity versus fixed
income or stocks versus bonds. In addition to these liquid assets
there would also be hard assets such as real estate, precious
metals, commodities and art forms that could be considered as
options. But the most important point is that deciding what the
most appropriate or optimum percentage of your assets should be
allocated to these various asset classes is a subject of much
debate.
Diversification-what is the goal?
The most common definition, and therefore use, of
diversification is as a risk management technique. This most basic
concept of diversification says that you should not put all of your
eggs in one basket. On the other hand, assuming that this is wise
counsel raises the question: how many baskets is the appropriate
number? Should you spread your money over 5 baskets, 10 baskets, 20
baskets, 100 baskets or 1000 baskets? In other words, what is the
optimum number of baskets; how many baskets are enough and/or how
many are too many?
When dealing with broad diversification, I refer you back to my
previous comments regarding equity versus debt. There are many who
advocate cute little rules that they promote as the proper way to
apply broad diversification. For example, one of the more popular
rules of thumb goes something like this: Subtract your age from 100
and put the resulting percentage in stocks; the rest in bonds. In
other words, if you're 20 years old, put 80% of your assets in
stocks; 20% in bonds. If you are 60 years old, put 40% of your
assets in stocks and 60% in bonds, etc. Somehow, these little rules
of thumb leave me cold. To my way of thinking, a proper asset
allocation plan should be based on the individual's goals,
objectives and risk tolerances. When dealing with these kinds of
issues, one size rarely fits all.
Next there's the issue of whether your diversification
objectives are geared towards reducing risk or maximizing return.
An investor with a high tolerance for risk would take a different
view of what optimum diversification is versus a person who is very
risk averse. An individual with a high tolerance for risk might
choose only to invest in equities in lieu of owning any fixed
income assets. Who can say that this is a bad decision when it
suits the investors' goals and risk tolerances? This then takes us
to the questions pertaining to optimum diversification within an
asset class.
The most interesting aspect of these important questions is the
fact that there is no consensus view. Some experts argue in favor
of more diversification while others favor less. For example,
Charlie Munger, the famed partner of Warren Buffett, believes that
3 to 5 companies in a stock portfolio is enough diversification.
Charlie is alleged to have said that diversification is for idiots.
And he is quoted as saying:
"wide diversification, which necessarily includes investment in
mediocre businesses, only
guarantees ordinary results. "
Alternatively, Warren Buffett seems to agree and has said:
"diversification is protection against ignorance."
In contrast, Peter Lynch, the famed manager of the Fidelity
Magellan Fund during its glory years held more than 1000 stocks in
his portfolio. What is most amazing about this fact is that Peter
created one of the strongest long-term track records of any mutual
fund that ever existed. Ironically, this is the same man who is
credited with coining the phrase "di-worse-i-fication." What many
people fail to realize about this is that Peter was referring to an
individual company diversifying outside of its core competency
through acquisitions. Yet when building his own portfolio, he was
happy to own hundreds or even thousands of individual
companies.
Then of course there is another aspect of diversifying within an
asset class. As it pertains to equities, investors could have a
choice of various classes of common stocks. These would include
growth stocks versus dividend paying stocks, small stocks versus
large stocks, etc. Once again, the investor is faced with the issue
of how much should be in growth, how much should be in value, how
much should be in large, how much of the small, and on and on. I
don't believe there is a general answer. The right answer is the
answer that best fits the individual's needs and goals.
And the same concept would apply to investing in bonds. A
prudent bond investor might want to ladder their portfolio over
various maturities. How much they would allocate to longer
maturities versus how much they would allocate to shorter
maturities would depend on their belief as to where interest rates
might be headed in conjunction with where they feel they are today.
If the investor feels that rates are very low they would want to
rely more on shorter maturities so that their money would mature
into higher interest rates, if they believe rates were going
higher. Conversely, if they feel that interest rates are very high
they would want to orient their portfolio to the longest maturities
possible in order to lock in the higher rates for as long as they
possibly could. These considerations would have a major impact on
their overall diversification strategy.
There is another argument that the Buffetts and Mungers of the
world offer against broad diversification. These investors who
favor a more concentrated approach believe in essentially two
things. First, they believe that extraordinary above-average
investments are rare. They further argue that every investment you
add would be, or should be, of lesser opportunity than your best
choice is. In other words, your best stock will generate a higher
return than your second best and so on. Their second belief is that
you can only truly know enough about a very select number of
companies to be able to invest wisely. Therefore, the more
companies you include in your portfolio, the more diluted your
knowledge about each will be. In other words they believe in
placing all their eggs in one basket (or at least a very few
baskets) and then watch that basket very carefully.
Diversification For Maximum Return Or Minimum
Risk
As I've previously alluded, diversification is most commonly
thought of as a way to reduce risk. However, the opposite side of
the diversification coin is rate of return. Diversification, or the
lack thereof, will have or should have a large and direct impact on
the ultimate return that a portfolio will generate. However, the
precise impact is once again a matter of debate. For example, in
theory, the more fixed income a portfolio contains the lower the
rate of return it would be expected to generate. In his
best-selling book Beating the Street, Peter Lynch offered up this
26th Rule of his 25 Golden Rules of Investing (yes, it was his 26th
of 25):
"in the long run, a portfolio of well-chosen stocks and/or
equity mutual funds will always outperform a portfolio of bonds
or a money market account. In the long run, a portfolio of poorly
chosen stocks won't outperform the money left under the
mattress."
Or you might prefer Peter's principle number two:
"gentlemen who prefer bonds don't know what they are
missing."
Perhaps the moral of this story is that diversification has its
pluses, but also has its minuses. While it can protect against risk
and even smooth out long-term returns; it accomplishes all this at
a cost. The seminal question is whether or not you, the individual
investor, is willing or even capable of paying the price? Or put
another way, how much rate of return are you willing to give up, to
buy how much peace of mind? Again, I see this as an individual
decision, and perhaps even more importantly, a function of the
amount of knowledge you the individual investor possesses and the
amount of volatility risk you can endure. Clearly, most of us are
not Charlie Munger or Warren Buffett that can afford the luxury of
a highly concentrated portfolio. On the other hand, we don't want
to be guilty of "di-worse-ification" either. At the end of the day,
finding the right balance is as much a personal thing as it is an
ironclad principle. At least it is in my way of thinking.
A Fun Look at Diversification Within the Asset Class
Equity (stocks)
As I went through the process of researching diversification I
came across some interesting results that frankly astounded me.
Therefore, I thought it would be fun to share what I discovered.
First of all, the primary goal of my research was an attempt to
ascertain how much diversification within an asset class was the
appropriate amount. Stated more simply, how many stocks were enough
to protect the money and how many stocks were too much to dilute or
destroy returns. Although I didn't come up with a precise answer
that satisfied me, I did discover some fascinating numbers.
Utilizing the our research tool I ran 20-year track records on
several well-known indices that contained a low of 30 stocks all
the way up to 5000 stocks. Before I ran these various records, I
assumed that the index with the least number of companies would
produce the highest rates of return and vice versa.
30 Dow Jones Industrials' 20-year Record
My first example is the DJIA, because it is a diversified
portfolio but only contains 30 names. As expected, the 30 Dow Jones
Industrials did produce the highest rate of return at 7.3% per
annum.
(Click to enlarge)
The S&P 500 Without Dividends
My second example is the S&P 500. Since the index contains
500 companies, I expected to see a lower annual rate of return due
to the much broader diversification. Even though I was correct, the
return differential was only 1.2% per annum coming in at 6.1%. From
the standpoint of risk, you could say that you didn't give up much
return for the greater safety.
(Click to enlarge)
Since this article is all about diversification, I have included
the sector breakdown of the S&P 500 in order to illustrate the
diversification within this broad index. I found it interesting
that Information Technology was the biggest sector at 20.46%. To me
this indicates that the S&P 500 is actually an aggressive
index, even though it is diversified.
(Click to enlarge)
R
ussell 3000 Index Without Dividends
With my third example I increased the size of the universe by a
factor of 5 by calculating the Russell 3000. Astonishingly, this
larger universe actually generated a modestly higher rate of return
of 6.3% per annum versus 6.1% for the S&P 500. In this case,
greater diversification actually increased my return, but not by
very much.
(Click to enlarge)
The Dow Jones Wilshire 5000
With my final example I calculated the Dow Jones Wilshire 5000
composite which at 5000 names was the biggest index I could find.
Remarkably, this biggest index of all produced the second highest
rate of return at 6.4% per annum.
(Click to enlarge)
Frankly, I'm not really certain what to make of the results I
discovered. From what I learned, diversification doesn't really
impact the rate of return by very much when looked at from the
perspective of the average company in the universe. This led me to
wondering what a universe of the top 10 best performing stocks
might look like. Of course I recognize that the flaw in this line
of thinking would be having the foresight to pick the top 10 at the
beginning of this exercise. However, my curiosity was not about
being smart enough to pick the very best; instead, I was just
curious to know what the differentials would actually be.
Therefore, I first sorted the top 10 of the 30 Dow Jones
Industrials and listed them in order of best-performing to
lowest-performing for the past 20 years. The average performance of
an equally weighted investment in each of these candidates would
have averaged approximately 13.8% per annum which is just shy of
doubling the rate of return for the entire composite of 30 names.
To put this into perspective, $1 million equally allocated total
investment spread into these top 10 companies would grow to over
$12 million in 20 years. I thought this was interesting, but not
terribly exciting. The following table shows the results of the top
10 best-performing 30 Dow Jones Industrials with $100,000 invested
in each at the beginning of 1993.
(Click to enlarge)
With my second example I went to the larger universe of the
S&P 500. With a much bigger universe to draw upon a discovered
a significantly higher average rate of return. As it relates to
diversification, I'm really not sure what this means other than a
bigger universe offered a much bigger opportunity to find
significantly above-average investments. The top 10 best-performing
S&P 500 companies produced an average return of almost 25% per
annum. Therefore, the same $1 million equally allocated across
these 10 names grew to over $68 million. Now, that number got my
attention.
(Click to enlarge)
Now, once again, admitting that this last little exercise is
fraught with error, I do feel that it revealed some interesting
information. Perhaps most importantly, it did reveal a large
disparity between the best performers versus the average
performance. If you did possess the skills of a legendary investor,
you just might be better served to focus your attention on only a
few of the very best companies you could identify. However, for the
rest of us we might be best served by placing our money spread out
and into more baskets.
Summary and Conclusions
As I began digging into the many faces of diversification, I
quickly learned that it is a much more complex concept than at
first meets the eye. But perhaps most importantly of all, I feel I
learned that there is no one-size-fits-all or even a set of
universally applicable rules or principles. To a great extent,
diversification turns out to be a very personal issue. How much or
how little depends more on your goals and objectives, the knowledge
and experience you possess, the time you can allocate to your
investment portfolio, and of course, your tolerance for risk. Some
of us need a great deal of diversification, while others could do
with a lot less.
I will conclude this article by confidently stating that it only
scratches the surface of what a comprehensive treatise on
diversification would require. In many ways, I feel that I raised
more questions than I answered. Therefore, I expect that more
articles will be forthcoming. The one area that I feel I
shortchanged the most was the area of broad diversification across
many different asset classes. Consequently, an article dealing
specifically with this aspect of diversification seems like a
logical next step. However, I will end by saying once again that I
believe that it is also a very personal concept. On the other hand,
I do believe that no asset class should ever be used unless it
makes prudent economic sense to include it.
Disclosure: Long MCHP, MSFT, CVX, ESRX, XOM, UTX, CSCO &
INTC at the time of writing.
Disclaimer:
The opinions in this document are for informational and
educational purposes only and should not be construed as a
recommendation to buy or sell the stocks mentioned or to solicit
transactions or clients. Past performance of the companies
discussed may not continue and the companies may not achieve the
earnings growth as predicted. The information in this document is
believed to be accurate, but under no circumstances should a
person act upon the information contained within. We do not
recommend that anyone act upon any investment information without
first consulting an investment advisor as to the suitability of
such investments for his specific situation.
See also
Bankable ETF Strategy: Hidden Bear
on seekingalpha.com