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Diversification myths

Inasmuch as it has become standard practice as a technique for reducing risk, in the words of Warren Buffett: “Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.” Unfortunately for investors, our industry – although it hates to admit it – doesn’t always know what it’s doing. It also harbours some major hang ups about looking wrong that diversification helps to obscure.

Don’t get us wrong – we’re proponents of diversification. But it’s become overdone in this business, is no magic panacea and can actually do more harm than good when it comes to you reaching your investment goals. Join us for some diversification myth busting and discover the real deal behind this investing truism.

Myth #1: You have to be diversified to make money as an investor. 

Conventional wisdom says you should buy stocks in many different companies across many different industries in order to be “diversified.” The thinking is that by spreading your luck across as wide a swath of the investment universe as possible, you diminish the likelihood that any one business or sector will bring down your entire portfolio (more on that under myth #2).

On the flip slide, you set yourself up to make gains somewhere, sometime – or so the thinking goes. You don’t want to exclude potential profit areas. Since you don’t know in advance which of your available options are going to be the moneymakers, better to try them all in the hopes that something will pop.

At the heart of this reasoning is a deep sense of uncertainty around what makes a good investment. For example, the average investor can say with confidence how much a cup of coffee is worth whereas Tim Hortons’ value as a business is much harder to ascertain. Even so-called investment professionals don’t spend the time or have the patience to commit to researching an investment idea and sticking with it for the long term. Their lack of conviction is reflected in the watered-down products they push.  

Successful investors like Warren Buffett don’t broadly diversify because they don’t need to. Buffett prefers to make big bets on a few companies that he knows intimately. He focuses on what he understands and therefore is comfortable investing in. He understands his particular areas of specialization thoroughly enough that when he becomes convinced a particular stock is undervalued, he’s confident enough to make a substantial investment. On the surface it might look like he takes on a lot of risk by owning such a relatively concentrated portfolio of holdings as what’s in Berkshire Hathaway. However, it makes perfect sense when you consider his alternative: investing in businesses that he’s unfamiliar with or that he doesn’t like as much as his top holdings, thereby hedging against his favoured picks. Now there’s a risky endeavour.

Despite Buffett’s success, you don’t see his approach widely adopted today because so much of our industry avoids what’s called “career risk.” This is the fear of negatively impacting sales into a product or, worst-case scenario, getting fired if an investment doesn’t work out as expected. Investment managers tend to want to mitigate the risk of their decisions on their financial security. They know they’ll dodge criticism and scrutiny by playing it safe. They simply aren’t willing to stick their necks out and would rather be considered run-of-the-mill than take the chance of looking wrong and losing money, even if for only a short period. Instead, they diversify to the point of holding multitudes of stocks such that they mimic their benchmarks both in what they own and in their investment returns.

A lot of evidence highlights the merits of holding a relatively small number of stocks, somewhere around 30 and 40 businesses at most. Investment managers whose assets are concentrated in their best ideas have consistently outperformed more highly diversified portfolios. And, in general, these pure “best idea” portfolios delivered strong returns without added risk.* Safety – and investment success – in fact lies in well-researched investment choices. Because the more you know about a business, the greater your informational advantage over other investors. This helps in identifying mispriced securities, which in turn creates opportunities to outperform while decreasing risk. Assuming it’s varied enough in its holdings and operations and you bought it at the right price, even a single business can provide all the diversification you need. The path to outsized returns is more about how much you know than how much you own.

Myth #2: Diversification protects you against losses.

The crazy thing about most interpretations of diversification is that taking losses is part of the strategy. When you decide to own a bit of everything you accept with open arms everything that comes with it, from the good, to the bad and the ugly. Consider the investor who spreads their money around into various investments and end ups with half doing well while the other half does poorly or even loses ground. Their resulting rate of return is low, probably average at best. Overall they won’t look like they’ve made any mistakes as their losers get cancelled out by their winners; then again, they won’t necessarily make money nor will they achieve their long-term investment objectives.

Diversification as it’s commonly sold doesn’t provide that much protection anyway. Granted, if you own 100 companies and one blows up, you’ll barely notice. You’ll still have the other 99 to hopefully keep you afloat. In contrast, if you own just one business and it blows up you could be in trouble. What happens if the entire market blows up as it did in 2008 and you own one high-quality business and 99 mediocre ones? You can depend on the superior business eventually bouncing back much more so than you can the other 99. The illogic of diversification is that to be “safe”, investors are expected to own a large basket of stocks that may include some exceptional companies but by its very definition must also include second-rate ones. How safe is it to gain exposure to average or below-average investments?

Never mind that diversification can’t buffer your portfolio from market shocks. Another of diversification’s tenets is to allocate your portfolio across a variety of investment vehicles, such as cash, stocks, bonds and real estate. In periods (like 2008) when no sector or asset class is immune from market carnage, this form of diversification won’t help. Everything has the potential to tumble at the same time. Your rebound will likely depend less on sector or asset categorizations than on the growth potential of the individual businesses you own. Whether it’s avoiding losses or making gains, the quality of your investments should always trump their quantity.

Myth #3: Lots of colours on a pie chart means you’re diversified.

Some products claim to be diversified because they invest in a number of different positions, which gets demonstrated using multicoloured pie charts. In practice, however, these investments can be loaded with holdings that share common fundamental drivers.

Part of the problem is that how assets are labeled can be misleading in that the labels don’t always accurately describe the behaviour of those assets. Case in point: bonds are supposed to act differently from equities. In reality this convention is overly simplistic – certain investments tagged as bonds can behave more like equities and vice versa.

These labels also imply that asset relationships are constant over time even though historical behaviour isn’t necessarily indicative of what will happen in future. Take bonds again. It’s assumed that they’re forever negatively correlated to equities when really the strength of this correlation can vary significantly depending on the period. 

In another instance of mislabeling, businesses categorized under the same sector can otherwise be completely dissimilar. Diversity within sectors often goes unacknowledged such that you could hold multiple businesses classified as “financials” that are nevertheless uncorrelated to one another. They might be insurance companies, banks, real estate brokerage businesses and the list goes on. In other words, you need only dig down a bit to discover a far greater range of investment ideas than what the term “financials” seems to suggest. The same holds true for all sectors.

Geographic breakdowns take the cake for being the most absurd way to reflect diversification if you ask us. A business’s stated geography is based solely on where it’s headquartered. This can have nothing to do with where it actually does business. A company may be domiciled in Canada yet report in U.S. dollars, trade on the NYSE and do 98% of its business outside of the country. Not very Canadian after all. Regardless, what does it truly mean to be a Canada-based, U.S.-based or Italy-based company and is location what investors should be concerned with? Of course not. This is useless information and not what you should base investment decisions or a risk minimization strategy on.

Breadth of holdings alone doesn’t guarantee diversification and neither do sector or geographic distributions. “More” doesn’t automatically translate to “better.” Overdiversification can inadvertently overcomplicate your financial life and leave you with higher transaction fees, more risk, adverse tax consequences and a diluted investment portfolio that will never get you ahead. Who wants that?

Avoid the diworsification trap

Having a glut of investments isn’t smart diversification. Believing your portfolio is bullet proof because it’s diversified according to traditional thinking isn’t smart investing. There’s only one way to be a better investor and that’s through a sound financial education. With the proper knowledge you can be selective about your investments and focus only on what works for you. This involves being savvy enough to recognize that the most common forms of diversification are practiced by a self-serving industry (ours) that doesn’t give a hoot whether or not you make money. Be informed so that the next time someone throws around the d-word, you’ll think twice.

*Randolph B. Cohen, Christopher Polk and Bernhard Silli, Best Ideas, MIT, London School of Economics, Goldman Sachs, May 1, 2010.