One of the most fundamental principles in investing is the concept of diversification. At Independent Financial Planning diversification is achieved through a variety of means. You’ve probably heard the expression, “do not put all your eggs in one basket” and that is the heart of diversification – using multiple means to achieve your goals. In the world of investments, diversification is using multiple investments with different characteristics to achieve long-term positive results.
The formal concept of diversification came about from an attempt to achieve the optimal portfolio. According to modern portfolio theory, the optimal portfolio is determined by having the lowest amount of risk for a determined level of return. Diversification, as it pertains to price movements of various securities, was determined to be the best way to reduce risk for a given level of return or conversely to provide the greatest return for the amount of risk an investor is willing to take.
There is a common anecdote that floats around contrary to diversification. It is often about the investor who put their life savings in Apple and is now able to retire even in their early 40s. It’s often the case that investors who have had outsized returns invested in concentrated positions. Warren Buffet said, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” There are also mutual funds and famous investment managers that keep their portfolios concentrated on only a few stocks, like the Fairholme Fund, FAIRX. Often these funds produce exactly the kind of returns over time that an academic would suggest – greater volatility in price movement. In the case of FAIRX, the manager was considered Fund Manager of the decade (2000 – 2009) by Morningstar only to have the worst performance in the history of the fund the following year (2011). Diversification then is revealed to provide safety and is not a method to achieve outsized returns.
Another difficulty with diversification is that it can be hard to find and investors may think they are diversified when they are not. A great example can be found in the average 401(k). Most 401(k)s offer a variety of stock oriented mutual funds and a very small number of bond oriented mutual funds. If an investor were to attempt diversification in a 401(k) of 14 investment options and chose five funds there is a chance that although each mutual fund would be considered diversified in itself, the combination would not make for a diversified portfolio. If all the funds were domestic companies, and not just that but they were all large domestic companies? The investor would have too much exposure to that part of the market.
Several books have been written about how much diversification an investor should have and how to achieve it. Some reference using different asset classes, like stocks, bonds, cash, futures, commodities, oil and gas partnerships, real estate investments, timberland, etc. Others suggest that investing across different sectors is enough, like consumer staples, energy, materials, healthcare, technology, utilities, etc. Still others recommend diversification only to 50 positions and not “Diworsification” similar to the sentiment in Warren Buffett’s quote.
I think there is reason to consider each type of diversification in a portfolio. As an investor desires less and less risk more and more diversification is helpful to the portfolio and likewise as an investor is willing accept more risk less diversification is needed. At Independent Financial Planning, diversification is among thousands of individual positions via exchange traded funds (ETFs) and across sectors and asset classes. Most portfolios will have private equity exposure, and all have stock, bond, and cash allocations. Sign up for the newsletter or send a note through the questions tab if you’d like more information.
