“Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep by him in reserve.”
So it is written in the Talmud, a record of debates among rabbis about Jewish law dating as early as 220 C.E. In investment circles, this quote is well known. It is an interesting reference to a properly diversified portfolio, dating back almost two millennia. (Here I must offer my apologies to our quantitative analyst, Sauro Locatelli, who will probably be asked by Rick Vollaro, our Chief Investment Strategist, to do a 1,800 year back-test of this model to see if it would add alpha to our managed accounts.) Portfolio diversification is one of Pinnacle’s two unbreakable rules of investing, the second being not to buy overvalued assets. If you are a student of Modern Portfolio Theory, the reason for diversification has much to do with owning a variety of asset classes with high returns and low correlations that land you on something called the “efficient frontier.” The diversity of the asset classes in the portfolio typically adds to the probability that you will theoretically earn the highest returns per unit of risk taken, thereby allowing professional money managers to claim that they have properly managed risk for their clients (and I might add, to do so using a mystical and unfamiliar language of financial gobbledy-gook that helps assure clients that their advisor is indeed a professional).
However, diversification must be done properly, or so the theory goes. The term for not properly diversifying a portfolio, or using assumptions that lead to a portfolio that actually has higher risk for each unit of return (or is more “inefficient” than it would otherwise be), is “diworsification.” I have heard this word often over the years, most notably by a local money manager who specializes in investing in concentrated portfolios of individual stocks. He often used the term diworsification to describe the portfolios of advisors like Pinnacle who insisted on using multiple asset classes in their portfolio construction. It was also used to describe individual stock portfolios that owned too many stocks, thereby diversifying away any possibility of earning above market returns. During the late 1990’s, his portfolio of 20 or so individual names dramatically outperformed the markets. However, the subsequent market decline from 2000 to early 2002 almost put him out of business.
(I was stunned to discover that a search of the term diworsification had 6,070 hits on Google; so clearly, I’m not the first investor to have something to say about the problems of properly diversifying a portfolio. As regular readers of this blog know, I tend to rant about diversification issues with disturbing regularity.)
I think the ‘Talmudic portfolio’ referenced above is actually a wonderful case study for diversifying, or diworsifying, a portfolio. It is notable that the portfolio includes a 33% asset allocation target for land. For most of us, home ownership includes some land, which I think meets the requirement for this particular asset class target. Depending on the size of their mortgage, some of our client’s home equity may rise to the 33% allocation suggested by the Talmudic Portfolio, at least in terms of their total assets. However, home equity, or land equity in this case, typically isn’t considered a portfolio asset. Holding assets “in reserve” seems to be a reference to cash, however Federal Reserve Chair, Ben Bernanke, has gone to great extremes to rescue the banking sector at the expense of savers, so holding 1/3rd of your assets in cash doesn’t seem to make much sense when cash pays nothing. It is probably worth pointing out that we know of several bearish analysts who would prefer both land and cash to stocks and commodities in the current volatile market environment.
The portfolio allocation of most interest to me is the 33% target allocation to “business.” For most of us, investing in business is done by owning shares in publicly traded companies. You can purchase shares in the stock of any one company, or you can invest in a portfolio of businesses by owning shares in a mutual fund or exchange traded fund (I assume that ancient Talmudic scholars did not have the opportunity of investing in ETFs). Most professional financial advisors would have a heart attack if a client wanted to allocate such a high percentage of their portfolio to any one publicly traded stock, unless it was the client’s privately owned company. From a planning perspective, an operating business is not considered a portfolio asset and doesn’t get mentioned in a discussion about asset allocation, other than to agree that the risk of the business can be substantial relative to other investment risks that we attempt to manage in our diversified portfolios.
Proponents of diworsification point out that the more our ownership of business is diversified, the less chance we have of accumulating great wealth. For example, try telling someone whose portfolio consisted of 100% Apple stock for the past twenty years that they should have been more diversified. Good luck with that conversation.
Diversification is the simple manifestation of the rule of “not putting all of your eggs in one basket.” Overlooking the simple step of diversifying a portfolio is a recipe for scrambled eggs. I had an interesting experience in that regard last year when I was asked to speak at the Club X Family Office conference — a private gathering of super wealthy family offices — by Tony Boeckh, the current President of Boeckh investments in Toronto, and former long-time editor of BCA Research. The topic I was asked to speak about was tactical asset allocation, and I was shocked to find that most of the super-affluent investors in the room had absolutely no idea what I was talking about. These investors, whose average net worth was in the hundreds of millions of dollars, found the whole notion of diversification to be absurd. Just about every one of them had created great wealth by making large, concentrated investments in one or two operating businesses. From their perspective, the very notion of diversification represented diworsification, because by definition, their particular portfolio was already optimal, or efficient. When you create hundreds of millions of dollars of wealth by investing in two or three businesses, then by definition risk was properly managed. With the advantage of 20-20 hindsight, their view was that investing in a large portfolio of stocks, not to mention multiple asset classes, was certainly an exercise in diworsification.
Yet, diversification remains our first rule of investing. Here’s why:
- Our goal in building diversified portfolios is to eliminate the risk of owning an individual business. The Club X participants mentioned above represent a skewed sample of investors who won big by allocating large sums to an investment in a single company. The list of investors who lost everything by making concentrated bets on any one individual business is long and tragic.
- Diversification is a strategy for those who want investing to be boring. Ignoring diversification leads to lots of potential excitement in reviewing returns, which can mean exciting gains, and exciting (i.e., horrifying) losses.
- Diversification eliminates the possibility of earning massive returns in exchange for the potential to earn systematic returns. Investors who diversify their portfolio believe that earning a “reasonable” premium above risk-free investments over time is good enough.
- Investors who diversify their portfolio must be skilled at remembering that the total portfolio can never earn the returns of the single best performing asset class, and the returns of any one asset class will never be as high as the best individual security in the asset class. Those who believe that diversification is diworsification typically focus on the winners and forget about the losers.
- In the context of Modern Portfolio Theory, diversification works best when correlations are low. When asset classes are zigging and zagging in different directions, as they have in the past, then overall portfolio volatility is reduced and investors earn higher returns per unit of risk. However, the rule seems to be that in bear markets correlations tend to peak. This means that just when you need diversification to work best, it often doesn’t. The result is that in bear markets great care must be taken to avoid a diworsified portfolio. When correlations peak, it’s a good time to remember that investors who made large, often leveraged, bets on an individual business are not worried about volatility that is higher than expected – they’re worried about losing 100% of their invested capital.
- Diversification is the simple manifestation of the rule of “not putting all of your eggs in one basket.” In our view, successful investing has a lot to do with avoiding large investment mistakes. Overlooking the simple step of diversifying a portfolio is a recipe for scrambled eggs.
- Finally, as I mentioned earlier, diversification is the first of our two rules for portfolio construction. The second is to avoid buying overvalued assets. It is the combination of the two rules that allows investors the opportunity to outperform broad market averages by tactically changing the asset allocation of the portfolio.
Therefore, we proudly acknowledge that we are diworsifyers in the eyes of those who view investing as a casino game where you win big, or lose big. Hopefully, Pinnacle clients see the benefits of trying to reduce the odds of getting wiped out by the house.