Logical people that we are (spoiler alert; we’re not)…we know that when you put all your eggs in one basket, it’s certainly efficient and keeps you from making two trips. But, as soon as I mention ‘all your eggs’ and a ‘basket’, even today’s younger adults hear that old cautionary adage ring in their heads. It is vastly underappreciated by most households how important the financial concept of “diversification” is when a person is investing. In this month’s letter to you I will try to describe why that concept is #3 on my list of the Top 7 most important concepts for being financially successful.
There are various reasons why diversification is important. The first one is simple; You can’t fight another day if you are dead. Concentration is the opposite of diversification. When investing for a high probability of success, concentration is generally bad. Nonetheless, there is this whole notion of ‘hitting the ball out of the park’, and it’s a natural allure when we hear of extravagant lifestyles of the rich and famous, or far worse yet, when our moronic brother-in-law brags about his great investment. But never forget that basic to the notion of successful investing is the reality that to make money you need to have money — and when you strike out, you aren’t at bat anymore. You have no more swings coming to you. When you don’t have money, the algebra of the 9th Century Persians *(Muhammad ibn Musa al-Khwarizmi) still applies; Some Rate of Return x Nothing = Nothing.
The second reason is simply to appreciate the great role that luck plays in any business. It’s not simply a matter of how much capital you have, or your intellectual property, your dedicated employees, or your position in the marketplace. All of those are important, and having been the CEO of five companies, I can attest they are vastly important. But there is also the daily reality of how brutal the competition is, and you generally lack insight to the moves that they will make. Or, simultaneously, you don’t appreciate how fast the marketplace itself moves and the pain experienced if you don’t keep up to the shifts underway. Growing to be a large company is a testament to the organization getting an awful lot of things right…but even large companies (large capitalization) have a hard time staying there. Consider this fact; Only 10% of the companies in the S&P500 in the year 1955 are still on the list[i]. Competition and the relentless presence of Schumpeter’s ‘creative destructive’ have taken out the other 90% of the companies that once existed. Some of those once formidable names aren’t even recognizable today (Armstrong Rubber, Cone Mills, Hines Lumber, Pacific Vegetable Oil, and Riegel Textile). In a recent study, it was estimated the former lifespan of being on the S&P500 of 33 years will decline to 12 years by end of this decade[ii].
Third, if we can’t recognize who might fall off the big list, are we any better at recognizing who will grow onto it? Will we recognize the next Nvidia, or will we instead see great promise in the nascent Netscape browser, or Pets.com model? In his book, “The Psychology of Money”, Morgan Housel recalls a J. P. Morgan study where the returns of the Russell 3000 Index were examined since 1980. Though returns for stocks might average 10%, the study found that effectively ALL the returns of the index came from just 7% of the companies who outperformed by at least two standard deviations. Keep in mind that every one of these companies were successful enough to warrant listing as a public company and at roughly $1 Billion or more market capitalization, they aren’t chump-change entities. Further upping the odds from an investor standpoint, due to SEC regulatory changes beginning after the year 2000 dot.com bust, all publicly traded companies must adhere to tightly controlled and simultaneously released financial information. If you then combine the vagaries of any single individual company success with micro-second speeds of information release (much less with Artificial Intelligence added to the fray), it’s simply hard to find an edge.
The final reason for diversification overrides all the above points. It sounds slightly mathematical, but the notion of ‘uncompensated risk’ should never be forgotten. Financial markets work because Risk = Return (always and forever). Every single stock listed on exchanges around the world must deliver an expected rate of return. Let’s say that return is the historic roughly 10% per annum. However, if you buy an individual stock, it’s standard deviation is 200%-300%[iii] more than the markets standard deviation. That means you are taking risk (concentration) that is uncompensated: i.e. you are not being paid enough to take it. You would only do that if you weren’t logical…which we all imminently vouch that we are of course. One of the common psychological investment mistakes I’ll address in a later letter is called the “Overconfidence Bias”, and this…is that. I hope you are lucky, but the odds aren’t in your favor.
For all the supportive rationale given above, you might now have a better appreciation of why Nobel laureate Dr. Harry Markowitz, an iconic and early financial markets researcher said: “Diversification is the only free lunch in investing”. Though it probably goes without saying, if you are a client of Wellspring, you are massively diversified as an investor, exceeding the number of equity securities held in the wonderful worldwide index fund of Vanguard (VT) by roughly 50%[iv]. In that process, you get great market returns and safety at the same time.
If remains my deep and distinct honor to serve you well.
Patrick Zumbusch
Founder and CEO
[i] “Only 52 US Companies Have Been on the Fortune 500 Since 1955, Thanks to the ‘creative Destruction’ That Fuels Economic Prosperity” (Mark Perry, American Enterprise Institute, June 3, 2021)
[ii] “Traditional company, new businesses: The pairing that can ensure an incumbent’s survival” (Phillipp Hillenbrand, et al, McKinsey and Company, June 2019)
[iii] “Have Individual Stocks Become More Volatile; An Empirical Exploration Of Idiosyncratic Risk” (John Campbell / M. Lettau / B. Malkiel / Y Xu, National Bureau Of Economic Research, March, 2000)
[iv] 52.1% (Investment Products, Vanguard VT (9,961) versus Dimensional Core II (2,374), International Core (7,529), Emerging Markets Core (7,529) and Domestic Real Estate Securities Portfolio (137), (total 15,153), September 28, 2024)
