Diversification: Watering Down Returns

Why do we hear so much about diversification?

Well, think about who’s pushing diversification. It’s financial advisors who charge commissions from actively buying and selling stock to balance a portfolio.

  • What is the selling point of diversification? To minimize risk.
  • What type of returns can you expect from diversification? Average.
  • Do you know what else generates average returns? An index fund.

The purpose of an index fund like an S&P 500 fund is to achieve diversification through a comprehensive cross-section of stocks representing a diverse basket of industries as represented by the companies of the S&P 500.

The average return of the S&P 500 is the benchmark against which portfolio performance is measured. When we say a portfolio beats the market, we’re saying that the return from the portfolio beats the S&P 500.

Shouldn’t the point of hiring an advisor be to beat market returns?

If so, then why do advisors tout diversification so much when all diversification achieves is average returns? If we wanted average returns, we could just invest in an index fund free of fees.

Here’s why diversification waters down returns: It’s because most investors hire advisors. After all, they buy into the diversification scam Wall Street pushes. Not only do their portfolios not beat the market, but the average returns they could have achieved by investing in an index fund are now watered down by advisor fees.

You’ve heard of the power of compounding through reinvestment to achieve exponential returns over time, but have you heard of negative compounding?

​​When advisor fees dilute portfolio returns, these fees which could have been avoided by investing in an index fund have a negative compounding effect that has exponential diminishing effects.

Charlie Munger, Vice-Chairman of Berkshire Hathaway, who once famously said: “an idiot could diversify a portfolio” had this to say about the effects of advisor fees:

“Because of compounding, paying investment advisors end up costing more than most people think. If you make 5% a year and your money manager takes 2% off of that, the net reduction in your savings down the road is not 40%, it’s closer to 90% because of all the lost compounding.”

The point Charlie Munger wanted to make about diversification is that it doesn’t help you beat the market. If all you want is average, invest in an index fund. There’s no point in hiring a manager to do that and since more than 90% of managers can’t beat the market, what’s the point of hiring a manager at all?

Munger is a big advocate of investing in what you know because those industries and assets in which you have intimate knowledge will give you the best shot at beating the market.

The opposite of diversification is FOCUS – which is the idea of concentrating on one particular core competency but investing in multiple assets within that core competency – is the key to building wealth.

Diversification may preserve wealth, but concentration builds wealth. 

– Warren Buffett

At a shareholder’s meeting, to drive home the point of the power of focus vs. diversification when investing, Munger shared this story from his youth about a wealthy widow who lived in Omaha in the 1930s:

“This woman was one of the richest people in a town in the middle of the Depression. She had $300,000, which in 1930-something was an incredible amount of money.”

“She didn’t hire an investment counselor, she didn’t do anything like that – she just divided it into five chunks and she bought five stocks. I remember three of them: General Electric, Dow, DuPont – I forget the other two.”

“She never changed those stocks – she never paid any advisors, and only bought some municipal bonds with her unspent income. By the time she died in the 1950s, she had $1,500,000! No costs, no expenses.”

If you don’t have that experience, knowledge, or expertise, then lean on somebody who does. Leverage the expertise of others. That’s why people invest in people like Charlie Munger and Warren Buffett through Berkshire Hathaway.

​​Diversification only dilutes your returns with assets you have little knowledge about.

 

Focus on what works. Diversifying dilutes what works with what doesn’t work. Diversification waters down returns by diluting the winners with losers.

  • If you know what assets are winners why not just stick with that focus?
  • Diversification is fine if you want to achieve average returns, but why water down your returns if you’re invested in a cash cow?
  • You have experience, knowledge, and expertise in a particular cash cow, why dilute it with assets you know little about for the sake of diversification?

The type of diversification that would make sense, in this case, would be to invest in more cash cows but to spread them out geographically in case one location suffers drought or a natural disaster, then the cows you have in other locations can pick up the slack of the affected cows.

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About the author

Kyle Jones is a co-founder and Key Principal of TruePoint Capital, LLC. Kyle is responsible for the company’s strategic planning, investment decisions, asset management, and overseeing all aspects of the company’s financial activities, operations, and investor relations.

Kyle obtained a Bachelor of Science degree from Texas State University – San Marcos, where he also played Division 1 Baseball.