Investing well is hard… actually, really hard. On the other hand, people make it far harder than they need to and unnecessarily over-complicate matters, failing as a result. Further, to be fair, I think people on my side of the table (financial advisors) do a great disservice to their clients by making investing sound mysterious in an attempt to elevate themselves and their importance. However, there’s no magic to investing and many advisors in the industry act no better than the Wizard of Oz, charlatans exposed when the curtain is pulled back. One of those false portrayals is being too narrow on their investments and violating the best practice of investment diversification.
This letter addresses three key mistakes many investors make as it pertains to this key financial principle.
Three Key Diversification Mistakes
1. Concentration
First on the list is “concentration,” a term that by itself signifies it being the opposite of diversification. Concentration in investing means holding just one stock or bond, or too much of any one such security. Given that any stock has the same expected overall returns of the stock market in aggregate (say 8% – 12% per annum), but any singular stock has a volatility at 250% MORE than the market[i], it would be illogical to hold that one stock because you are not “compensated” for that higher risk. You may love some company…but never forget that stock does not love you back. You could “knock it out of the park” in buying a company, but you could also strike out. The negative effect on your lifestyle of striking out is not recoverable and commonly brings pain and stress to your life in addition to regret.
2. Stocks in the Same Sector
The second fallacy is thinking that you are diversified because you have more than one stock, but you buy all the same sector of stocks. For instance, in 2023, the performance of technology companies is all the rage. Some attribute this increase to the outsized current emphasis on artificial intelligence (AI), but it is true that the S&P 500 is up about 20% as of the date I write[ii]. However, it is little appreciated that if you would remove just 7 stocks from the S&P500 index through June 29th, the other 493 stocks would show almost no gain for the year[iii]. Said differently, 1.5% of stocks in the index are driving almost 100% of their 2023 gains. Three of those household name stocks (Amazon, Alphabet (Google) and Meta (Facebook)) are up 37%-143% in 2023. Then again, if you owned these same stocks for 2 years, you’d actually be negative in cumulative value and certainly less than the trending-positive S&P500 index[iv].
3. False Diversification
Lasty, investors sometimes make the mistake that they are diversified because they hold passive Exchange Traded Funds (which is good) but they errantly own all the same funds in different security holdings. That’s false diversification. For instance, a prospective client portfolio was recently analyzed by Wellspring. We found their advisor had put them in three different money manager funds (Invesco, Schwab and Vanguard) BUT these funds all covered the exact same market (in this case, Developed International Markets, but it could be Large Capitalization USA stocks, whatever).
A similar but also wrong perception is selecting different custodians because of not wanting to put “all my eggs in one basket” (though all are covered by SIPC). The problem with that approach is again duplication in investment exposure, but it is further aggravated by having additional trade fees and not being able to adequately manage the exposure of that one security or asset class (i.e. When do I buy? When do I sell?).
Disciplined Diversification
In the world of investing, diversification is not only a good principle for safety, but disciplined diversification also produces better long-term returns. The actual number of different institutional asset classes varies over time but suffice it to say that you do want to be in Sovereign Bonds as well as Corporate investment-grade bonds. You want to be in large capitalization domestic growth stocks (to catch the above trends, and you certainly are in them), but you also want to have mid-cap and small-cap stocks, large value stocks, and international and emerging market stocks. A tad of real estate would be good too (etc. etc.) because its correlation coefficient is beneficial. A classic research study going back to 1992 found that 94%[v] (or more) of the standard deviation in an investment (and thus the variation in returns) is solely related to the investment asset class that it is in (i.e. mid-cap value stocks).
The Power of Diversification
Because of that power of diversification, Wellspring clients are invested in at least 36 distinct asset classes. Our clients don’t just have different classes of investments, they have a lot of them, which is all part of the promised strategy of trying to provide the highest probability of predictable long-term returns that we can conceive based on the history of markets over the past 90-years.
It remains my deep and distinct honor to serve you well.
Patrick Zumbusch
Founder and CEO
[i] “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)
[ii] Year-to-date Performance of Schwab S&P500 Index Fund (SWPPX) (Yahoo Finance.com, July 25, 2023)
[iii] “Op-Ed; No One Saw The S&P 500 Surging 14% In The First Half Of 2023” (Michael Farr, CNBC, June 29th, 2023)
[iv] 2-year Comparison Chart, YahooFinance.com ((SWPPX, AMZN, GOOG, META), July 25, 2023)
[v] “Determinants Of Portfolio Performance” (G. Brinson, L. R. Hood, G. Beebower, Financial Analysts Journal, August 1986)
