Is diversification as smart as it's cracked up to be?

 David Peartree, The Daily Record Newswire

A few highly successful, high profile investors seem to believe that diversification is actually quite stupid. Let’s consider the case and decide whether diversification should be embraced or rejected by the typical investor.

Diversification is about managing risk. Everyone understands the proverb, “don’t put all your eggs in one basket.” Diversification is that and more.

Diversification means holding a sufficient number of investments across different asset classes and markets so that the failure of one investment does not materially impact an entire portfolio or threaten an investment plan.

Holding several asset classes moderates risk, assuming those asset classes do not move up and down at the same time or to the same degree. In finance-speak, investors want to mix asset classes with a low to negative correlation. Likewise, within a broad asset class like stocks, performance across markets does not necessarily move in lock step. At any point in time, U.S. and non-U.S. stocks or developed markets and emerging markets may produce very different returns.

Holding numerous investments within and across asset classes and markets insulates a portfolio from being brought down by one asset class, or one market, or one market sector, or even one particular stock that has gone into a funk.

The contrary of diversification is concentration. If the market is thought of as a haystack, concentration is about finding needles in the haystack. Concentration aims to find just a few outstanding investments with the potential to deliver superior performance.

Warren Buffett and his business partner Charlie Munger practice concentration, not diversification. Says Mr. Buffett, “If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess long-term competitive advantages, conventional diversification makes no sense for you.”

His partner, Charlie Munger, says, “In the United States, a person or institution with almost all wealth invested, long-term, in just three fine domestic corporations is securely rich.”

These superstar investors attribute their success to astute concentration, not diversification. To be sure, they also stress keeping their costs low and investing for the long-term rather than engaging in short-term trading, but concentration is their core strategy.

Who can gainsay Warrant Buffett and his partner? Is there anything left to be said in favor of diversification? It turns out, there is, and by the very people who don’t practice it.

While eschewing diversification for himself and his partner, Buffett believes most investors should accept diversification as a core practice. “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”

Index investing is really nothing more than diversification at the lowest possible cost. Here’s another example that starts by making a case for concentration but ends up supporting diversification.

In 2010, Stanley Drukenmiller, a star hedge fund manager called it quits after 30 years. He was not a household name like Warren Buffett or even Charlie Munger, but he had celebrity status in the hedge fund community. His first 27-seven years of stellar performance were followed by three years of frustrating underperformance to finish his career.

Drukenmiller, like Buffett and Munger, thought diversification was a stupid strategy. He favored putting all his eggs in one basket and then watching that basket carefully. But after 30 years, he admitted that he was worn down by the stress and challenge of trying to maintain his record.

In a post-retirement interview when discussing how he would manage his own accumulated wealth he reckoned that only three or four of his hedge fund colleagues were up to his standards and candidates for managing his money. Charlie Munger thinks that maybe the top three or four percent of the investment management world possesses the talent to produce superior, market beating investment results over the long-term.

So concentration can work if you have the acumen of a Buffett, Munger or Drukenmiller, or if you can identify a manager with that skill (including a replacement when that manager retires or dies). But those folks are a rarified lot.

For a graphical depiction of the value of diversification, find a periodic table of investment returns published annually by a number of sources. A table showing investment returns from 1994-2013 can be found at www.callan.com/research/periodic.

It illustrates the performance of various asset classes over a 20-year period.

The table is a reminder that from year to year the top performers rotate: the first become last and the last become first; winning streaks end abruptly; and there is no apparent predictability to the ranking of performance among asset classes from year to year.

Warren Buffett and a few others are at once evidence of the possibility of success through concentration of investments and an argument for the prudence of diversification. Concentration offers the possibility of great success, no question, but diversification offers a higher probability of success.

Buffett and Munger practice concentration but they preach diversification for most investors. Their advice amounts to “do as I say, not as I do.” So diversify.

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David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.