Diversification
Arguably,
diversification is the number one principle that you will receive from an
overwhelming majority of financial advisers or planners.
Diversification
has been promoted as a standard refrain for a long time as a way to reduce risk
in a portfolio, and so it does, in a sense.
The risk of
putting all your funds in just one or two stocks is higher than putting it in
one or two hundred, for example.
Hence diversification is the mantra, and so most investment
portfolios look alike, made up of a residential property, some shares, and a
superannuation account (which is usually more weighted in stocks).
Another reason
to diversify is that according to the Efficient Market Hypothesis, you can’t beat
the overall market and so the best approach was to simply buy the index and
receive the market return.
In other words, trying to select companies that will outperform all
the other was near nigh impossible, so don’t bother.
Buffett said that
diversification is for folks who don’t know what they’re doing.
He’s not rude,
but simply stating that unless you want to spend a lot of time looking a
company balance sheets and the ‘fundamentals’ (I’ve had half a life of preparing listed company financials; I seriously wouldn’t recommend it) you should heed his advice - buy and index fund, sit
back and collect the pot when you retire.
But the problem
for many people is that they won’t have enough for retirement, and so you could
be excused for asking if just buying an index fund (diversification) is the
best approach or is there a potentially better way?
Since the early 1980s
the world has undergone considerable change. Look at our parents’ generation - one job, one career, sometimes only one house, and a defined benefit pension scheme.
The path will be a lot different for younger generations.
Since the 1980s
there has been an increasing linkage between each country’s economy as they
expand trade in goods and services as each country connects, their stock markets
also start to increase their correlation.
If you look at the graph below, you
see that most of the major markets move in some kind of sync.
What varies is
the level of returns.
Very often, all
developed markets will move in unison, but returns will vary.
The US market may
return a positive 12%, the ASX 25% and the UK 16%.
Steve Moriarty reliably
informs me that around 60% of the time when the US market rises or falls on any
given trading day, the ASX usually goes in the same direction the next day (he
has the time to back-test these things).
While the annual stock market returns
may vary, the same applies to annual returns as well. Most years that the US rises,
so too does the ASX.
Unlike previous
generations, you can now invest in just about any asset class in any part of
the world.
So, it’s at least worth asking if diversification across asset classes the
best approach to wealth building is still. Maybe we can build wealth through a
little bit of knowledge/specialisation and investing within an asset class.
Now back to
Buffett. Notice he didn’t say spread your funds across asset classes. He said
most of us should just index as a way of diversifying. But for those who know
what they’re doing (specialisation through increasing one’s knowledge), diversifying
within one asset class can build wealth. Buffett is living proof as his
obsession with business and stock markets has made him extremely wealthy.
For another case,, in
my case, I specialised first in accountancy, and then in real estate.
Buffett does not
diversify broadly. Most of his funds are in stocks and only a few stocks. He
simply buys what’s cheap in the same asset class as a way to Build wealth rather
than diversify to the point where your returns are eaten away by the ‘need’ to
reduce risk through diversification.
Think about it
this way – your neighbour approaches you with an offer to buy their house at a
very cheap price.
You know with a high degree of confidence that you could buy
and sell it quickly to make good profit. Or join it to your property and sell
the 2 blocks together.
It would seem
rather silly to say, ‘thanks mate, but I’m really into diversification and
since I already have a house, another one would increase my investment portfolio
risk, so I’ll pass.’
Make sense? What
we are really talking about with diversification is how much knowledge you need
to build wealth.
Most of us specialise by going to university, getting a degree
(specialist knowledge) and hitting the workforce looking for more income.
Goldilocks portfolio
The Goldilocks
portfolio I think is for investors who don’t want to be completely passive in
their investment approach – that is, maximising diversification by simply
buying an index like the ASX 300 and then just letting it go.
This portfolio doesn’t
require too much knowledge but gives you a degree of diversification using
market indexes.
Here’s our
Emerging Markets Table again (you can use this with other asset classes such as
sectors, developed countries and investment styles, such as value and growth).
Note, that if you
put $1,000 into each sector in the chart, you would receive the average return
– that is made up of the good ones, the bad ones and the ugly ones all
combined.
Now, an
alternative would be to adjust the amount of funds (the weighting) between the sectors.
Think of it as diversification in funds allocated rather than the range
of asset classes you invest in.
If you have been
reading my previous posts then you know, this suggests giving the bottom sector
performers a little bit more weighting and letting mean reversion do its thing.
So instead, you
might, say, put an extra $250 (total of $1250) into the bottom 5 and say $750
into the top 5.
Now this won’t result in outperformance every year, of course, but back-testing
this approach to diversification shows that it has outperformed the market and
built wealth just as safely as a diversified portfolio across a myriad of asset
classes.
