Diversification: Don't Miss Out On Your Only Free Lunch

Of all the truisms about investing that Warren Buffett has come out with over the years, perhaps the most important one for investors to understand is this: “Risk comes from not knowing what you’re doing.”

Most investors, including many professionals, are simply unable or unwilling to acknowledge how little they actually know, or the risk that they’re taking as a consequence. Smart investors, by contrast, know their limitations and, instead of trying to predict the future, focus on owning a broadly diversified investment portfolio.

Peter Lynch is regarded as one of the greatest stock pickers of all time. Over his 13-year tenure, he turned Fidelity’s Magellan fund into the world’s largest mutual fund and a financial juggernaut. From 1977 to 1990, he averaged 29.7% annually, beating the S&P 500 in 11 out of 13 years, while never having a down year.

But Lynch didn’t build Magellan into a behemoth by broadly diversifying across the entire market. On the contrary, he made calculated, concentrated investments in his skillfully researched portfolio. So also did Warren Buffett in growing Berkshire Hathaway; and Bill Ackman who maintains highly concentrated bets in his Pershing Square fund. So why diversify?

With respect to your investment strategy, are you as good at picking individual companies as the likes of Peter Lynch, Warren Buffett, Bill Ackman, George Soros, John Templeton, or other investing greats? If you are that good, you can stop reading. If you’re not, you may want to continue on.

Be Good, Get Good, Or Give Up

When it comes to investing for retirement, giving up is not an option, so either you are already good, or working to get good.

The Merriam-Webster dictionary defines ‘ignorance’ as a lack of knowledge, education, or awareness. When it comes to financial planning, self-awareness is crucial. As average investors, we generally do not have the in-depth knowledge, experience, intestinal fortitude, and time needed to properly research concentrated stock investments for our entire Financial Independence (FI) Portfolio.

We need to understand the outer edge of this border where our knowledge ends and our ignorance begins. This is where diversification comes in handy. For the average investor, unlike the notables mentioned above, diversification is part of ‘getting good.’

Protection Against Ignorance

Diversification is not how you make money in the stock market; it’s an insurance policy against incurring crippling losses. If you are familiar with the game of tennis: diversification is more akin to avoiding an unforced error than hitting a winning shot.

Risk is a direct descendent of fear. The brain’s fight or flight response to big change is based on fear – the brain perceives risk and tries to get away and avoid that risk. Knowing what you are doing, helps eliminate the fear and reduce the risk. As it turns out, Lynch and the others didn’t want or need the insurance because they had strong convictions in their company research and selection process, and the guts to stick it out. Can you say the same?

Concentrate On Not Losing

A concentrated portfolio (in winners!) is the best chance for outperforming the market but the cost of being wrong can be catastrophic. Diversification is the embodiment of the adage: the best offense is a good defense. According to Buffett, investing Rule Number One: Never lose money. Rule Number Two: Never forget Rule Number One.

Whether you are in the accumulation stage or withdrawal stage, diversification provides safety and protection from the permanent loss of a significant chunk of your FI Portfolio. It helps you to preserve your wealth, which in turn allows your wealth the opportunity to grow. It positions you to achieve your long-term goals.

A Cost Worth Paying

The relative safety that diversification provides, however, comes at a cost. The cost is giving up a shot at excess (market-beating) returns. But as I’ll discuss in a later article, this is a worthwhile trade-off since we don’t care about beating the market or keeping up with the Joneses. We do care about reaching our personal FI goals and, frankly, being able to sleep at night.

An S&P 500 Index fund provides a lot of diversification, but don’t lose sight of how it interacts with your personal timeline and goals. While the S&P 500 index is a large group of 500 companies and has performed remarkably well over the long-term, it represents only about 12% of all the listed companies in the US, and an even smaller subset (1.2%) of the 41,000 listed companies around the world. In the long-term, it might represent enough diversification for you, but if you have a shorter timeline, maybe not.

The “Lost Decade”

As an example, let’s think about a retiree at the beginning of 2000 with their $1m portfolio invested 100% in the S&P 500. For the next decade, 2000-2009, the S&P 500 returned zero (actually, slightly less than zero; an annual average of negative 0.95%). An unlucky and unpleasant position for our recent retiree. After the first ten years of retirement, our retiree’s portfolio value (before taking any withdrawals) would have declined by almost $100,000.

This so-called “Lost Decade,” however, turned out to be a good decade for investors who diversified their holdings globally beyond US large cap stocks and included other parts of the market— for example, companies with small market capitalizations, or value stocks.

A more diversified portfolio (for example, US stocks, foreign stocks, emerging market stocks, bonds, and real estate) averaged 6.7%--all during a timeframe that included the dot-com bubble, 9/11, the Iraq War, and the 08-09 financial crisis.

[NOTE: The following decade, 2010-2019, the S&P 500 return stormed back and averaged 13.5% per year for a cumulative two-decade average of 6%. And for those curious, the average annual return for the S&P 500 since adopting 500 stocks into the index in 1957 through 2022 is 10.2%. The long-term has been spectacular for the S&P 500 index, but the short-term is often a bumpy ride.]

Here is a mathematical fact: a concentrated bet in the RIGHT individual stocks will produce a better return than the S&P 500 or almost any other index. But what is the probability that you can pick the right stocks and stick with them for decades? And what are the consequences of you being wrong?

Winners And Losers

If you had picked one of the best performing stocks at the beginning of the Lost Decade, Green Mountain Coffee, a $10,000 investment would have grown to a tasty $889,000 over the 10 years (assuming you didn’t sell and take your profits somewhere along the way of that meteoric rise).

Alternatively, if you had instead chosen to put your entire portfolio into JDS Uniphase (a high-flyer coming out of the 1990s), you would have lost 99% and be looking at less than $100 remaining in your account. So, do you have the chutzpah to pick one or two individual stocks for the next decade and invest your entire FI Portfolio in them?

And don’t be dissuaded from diversification by the following observation. By being properly diversified, you will never have the best performing portfolio. There will always be other portfolios that perform better than yours. Being diversified means that some of your investments perform worse than others (since not all your money was in Green Mountain). On the bright side, it also means that you will never have all your money invested in the worst performing investments (e.g., JDS Uniphase throughout the Lost Decade)! Avoiding catastrophic losses is more important than capitalizing on big-win opportunities.

Time Is Your Friend

Professional money managers may overweight their favorites to capitalize on what (they think) they know, but even they still diversify to some extent to protect against what they don’t know. No professional has a portfolio consisting entirely of just their single highest conviction pick!

No matter how bumpy the ride is in the short-term, the long-term is your friend. Here are the WORST long-term compound annual growth rates (using rolling 20-year periods) for a sample of popular U.S. asset classes from 1980 through 2021 (i.e., the 1980 annual result would be for the 20-years ending with 1980):

• Large-cap blend stocks 5.9% • Large-cap value stocks 6.4% • Small-cap blend stocks 9.0 % • Small-cap value stocks 8.9%.

You can invest in low-cost ETFs for any or all these asset classes. Looking for one stop shopping? A total stock market fund, such as Vanguard’s Total Stock Market Index ETF VTI might be a good place to start your search.

For your diversification to be effective, make sure your exposure to the various sectors and asset classes you end up choosing is consistent with your timeline and overall FI plan.

Don’t Miss Your One Free Lunch

As Harry Markowitz said, diversification really is the only free lunch in investing — and it’s a healthy lunch too.

Failing to diversify as an investor is like grocery shopping and simply filling your cart with 17 different brands of potato chips. That might work in the short-term, but for your long-term health, you also want to find room in the cart for staples like grains, fruits, vegetables, and of course, filet mignon!

As always, invest often and wisely. Thank you for reading.

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The content is for informational purposes only. It is not intended to be nor should it be construed as legal, tax, investment, financial, or other advice. It is merely my own random thoughts.