Diworsification

That is a term coined by Peter Lynch, the great portfolio manager from Fidelity. He ran their Magellan Mutual Fund fund from1977 until 1990 when he retired from running the fund at age 46. His fund averaged a 29.2% annual return, which was more than DOUBLE the S&P 500 stock market index, making it the best-performing mutual fund in the world.

He used it to describe companies, that specialized in one area, was doing well, had tons of cash on hand and then decided to branch out and get into other industries and businesses that they had absolutely no business being in!

For example, John Deere (the farm and tractor heavy equipment company), thought it would be a great idea to diversify into health-care management. This is well outside of what everyone at John Deere knows how to do, which is make green and yellow tractors.

They kept at it, trying to grow the business for 20 years, before throwing in the towel and selling it. What a waste of time and resources! They make lawn mowers, tractors, harvesting machines?!

Peter Lynch also made very concentrated bets within his Magellan Fund too, sometimes having huge holdings as a percentage of assets that helped boost his returns. He made sure that he didn’t “diworsify” his own fund by investing in stocks that weren’t exactly what he was looking for.

When it comes to investing diversification, here is what the all-time greatest investor, Warren Buffet has to say about it:

Diversification is only required when investors do not understand what they are doing

One of the most common investment foundational concepts is diversification. It is considered a cornerstone practice of investing. And here is the all-time greatest investor thumbing his nose on diversification!

Let’s see if he puts his money where his mouth is. Towards the end of 2020, Warren Buffet’s Berkshire Hathaway, had 78% of his investment portfolio in just 5 stocks! [1]

• Apple
• Bank of America
• Coca Cola
• American Express
• Kraft-Heinz

If you are wondering about his track record, here is a quick summary:

If you invested $100 with Warren Buffett in 1965 when he started, it would be worth over $2.7 million today (compared to what would be $200,000 if you had invested in the S&P 500 index). That is an average annual return of 20.3%, for a huge multi-billion dollar investment portfolio!

I bring up these two famous and successful investors as a counter-point to the knee-jerk reaction to diversify your investments.

The Argument for Diversification

Diversification isn’t necessarily a bad thing. After all, if you own just one stock, and it craters into oblivion, you clearly would lament not spreading your risk across other investments.

If you investing in just Amazon, for example…your entire portfolio would obviously rise up and down entirely based upon Amazon’s price movement. You are 100% exposed (obviously) to that one company’s performance.

Let’s say you diversified equally into a few other stocks, WalMart, Costco, Target and eBay

Now you are diversified, right? You certainly would been. Now you are in 5 stocks, so if Amazon goes to zero, you have lost only 20% of your investment, not 100%. So certainly, you are spreading your risk around, so that is good and makes some sense.

However, look a bit more closely at those other stocks. They are in the same category…consumer commerce/eCommerce. You are not diversified across industries. As it turns out, those 5 companies have a high degree of correlation, which means for the most part, they all go up and all go down together. Their movements are closely tied together.

It would make a bit more sense to invest across different industries, like healthcare or consumer products.

Diversification can also come from investing in large capitalization vs small capitalization companies, domestic vs. international, etc. There are tons of ways to slice and dice your portfolio to reduce exposure to any one area so that your risk is reduced by investing in assets that aren’t highly correlated.

That brings us to asset correlation….the key concept of diversification

Modern Portfolio Theory: Diversification that sounds good, “in theory”

Harry Markovitz is the Nobel Prize winning founder of what is called Modern Portfolio Theory (MPT). By using complex mathematical models, risk is managed using empirically derived historical means, looking at standard deviations and correlations. He called it mean-variance optimization.

When creating a portfolio of investments, the focus is on getting an expected level of return for an expected amount of risk. It formalized the process of owning different investments, rather than owning just one type. The key takeaway he uncovered is that you should not look at each individual asset’s risk on it’s own, but how that investment contributes to the entire portfolio’s overall risk and return.

This sounds good in theory and certainly does work…most of the time

However, there are major drawbacks.

The Argument Against Diversification

If you held ten stocks and three of them did really well, but the remaining seven did average to very poorly, you would obviously wish that you had held just those three stocks and not spread yourself so thinly across those remaining seven laggards.

This is what happens when you diversify….your returns get dragged down by the investments that don’t perform so well. It is expected and a sacrifice that must be made, because you never know when there will be a downturn.

So the reduced returns good times, because your investments show very low correlation levels. Your returns are dragged down by that low correlation.

You then have confidence in knowing that the same concept will protect you when things go south. Your returns won’t do down as much, because you are diversified.

However, when market takes a serious turn for the worse, when you absolutely need that low correlation to protect your portfolio, guess what happens?

All of the assets become super-highly correlated!

Modern Portfolio Theory, with all of it’s fancy slicing and dicing and Nobel Laureate-worthy mathematics and sophisticated concepts, loses all meaning when the market unravels. In the real world, there are times when the benefits of MPT is a mirage. It doesn’t exist.

In times of crisis, like the 2008 “Great Recession”, your previously diversified portfolio did not “act like” a diversified portfolio. Assets that had previously showed very little correlation to each-other became highly correlated,

In other words…everything went freaking down).

Take a look at these two images, the first is a list of asset correlations (between each-other) before the crisis in 2007, and the second is the same assets and how they correlated with each-other during the crisis in 2008.

FYI – A zero (0) is 100% uncorrelated (the two assets move in opposite directions at the same time) and a one (1) is 100% correlated (the two assets move in the same direction at the same time).

Notice how the same assets related to each other before the crisis and how they related to each other during the crisis. (To make it easy to see visually, they color-coded ranges of numbers, with dark green showing high correlation all the way through purple, the most uncorrelated)

When times were fine, many of these investment assets showed very low correlation…. with a mish-mash of correlated and uncorrelated assets and then BANG – during the crisis they pretty much were all in the same boat, moving lock-step with each other.

It is almost as if you owned just one asset in your portfolio.

I got these images from Option Alpha, which has an amazing blog post and podcast related to diversification. If you are interested in learning more about this subject, I highly recommend checking it out!

One might say, well…that “Great Recession” was a once-in-a-lifetime event. It won’t happen like that again?

Yeah?

What about the current Covid virus pandemic?

The EXACT same thing happened. Again.

Major asset classes that had been largely uncorrelated, snapped into correlation together.

Why I am not Diversified

My financial goal over the last three years has been focus on accumulating wealth within my taxable accounts. Sure, I’ve got a 401k. It’s got a lot of money in it. I even have a pension with a prior employer. Same thing…a nice chunk of change. And guess what…they are diversified in mutual funds and have done well. It’s a passive investment. 🙂

I also have had a good track record of investing and trading on my own for many, many years…but all within tax-deferred retirement accounts. I know what I’m doing when it comes to investing, but haven’t had the focus to grow accounts that I can use and spend today if I need to.

I had no financial cushion, no savings in a savings account. None. Zero. Let that sink in…

What if I lost my job? What if I needed $20,000 for something very critical? I had nothing.

So I went after growing my my taxable accounts up from nothing with a determined focus.

In a bit over three years, by setting aside money every month, I’m now approaching $100,000 in investments in my taxable accounts.

Had I put the money I set aside in diversified mutual funds, I would have a small fraction of that amount, maybe $22,000-$25,000 (by the way, I’m going to put together a blog post of all of my transactions, documenting my cost-basis and my returns).

I did this by not diversifying (like within a mutual fund), but by concentrating my investments across a very small handful of investments.

I took an active approach to investing. Rather than passively saving, investing in mutual funds…I put 100% of my focus in finding investments that I knew inside-and-out. Investments that I thought had not only a high-probability of working out in my favor from a risk perspective, but also had the potential for substantial, above average returns.

As a matter of fact, I considered many of these investments to be very low-risk, even though they had a high potential reward.

I did it by having a game plan, a focused approach, carefully picking my investments using sound fundamentals, technical analysis and a focus on finding investments that were starting to reach a stage where potential price appreciation was starting to occur (this last piece has been the key, I believe).

To borrow again from Warren Buffet, this quote sums things up well:

Diversification is protection against ignorance. It makes little sense if you know what you are doing.

Warren Buffet

In the coming months, I’m going to document how I did that and also put together a step-by-step guide on my methods and suggestions of how you could follow the same process.

Glenn