How Diversifying Goes Wrong

TruePoint Capital

Wall Street continually touts diversification because it benefits them. Wall Street makes money the more stocks an investor buys across multiple industries.

Diversification benefits Wall Street, but it doesn’t benefit investors.

Touted as a risk-minimization strategy, what is often lost in the discussion on diversification is that it is also a return-minimization strategy. Warren Buffett is not a fan of diversification. He once famously stated that “diversification is protection against ignorance. It makes little sense if you know what you are doing.”

What did he mean by this? He meant that if you know one or two particular industries that are consistently profitable, why dilute the high returns in those industries with stocks in industries that don’t perform as well?

Besides diluting away your returns, Wall Street diversification does little to protect you in a market crash where very few industries are spared in a widespread downturn. So, diversification throttles your returns in good times and offers no protection in bad times. What’s the use? None, if you know what you’re doing.

Let’s revisit Warren Buffett’s advice regarding diversification. My interpretation is that it’s better to focus on one or two asset classes with a long-term track record of performance and success. Why?

Because if you stick to these assets long-term, their track record suggests you will always come out ahead.

So why dilute the returns from these assets by spreading your capital across assets and in industries with sketchy or limited track records?

Ultra-wealthy investors don’t do Wall Street diversification. They stick to one or two proven asset classes like real estate or private company investments (private equity) in proven businesses, and they do it for the long haul. They do it for the long haul and peace of mind. They know that any slight dips in the market will eventually be ironed out. This strategy was validated during the COVID-induced recession.

In the early days of the pandemic in the second quarter of 2020, almost every commercial real estate (CRE) asset class suffered from the recession as delinquencies and vacancies rose. By the end of 2020, certain CRE classes like multifamily and industrial had already shown signs of rebounding. Most CRE asset classes are expected to fully recover by the middle of this year – demonstrating CRE’s resilience.

Although the ultra-wealthy shun the traditional concept of diversification, where risk is minimized through multiple stocks across multiple industries, they embrace a different kind of diversification – diversification across multiple subsegments across multiple geographic markets where the aim isn’t to minimize risk and preserve a portfolio but to preserve cash flow.

To the ultra-wealthy, cash flow is king because not only can it be compounded to accelerate wealth building, but it’s essential for replacing income from a job if the need ever arises from job loss or retirement. So, protecting cash flow is paramount in the ultra-wealthy investing playbook.

So how do the ultra-wealthy insulate cash flow and wealth building from downturns? By investing in CRE assets across geographic markets, asset classes, property types, and investment strategies.

The right mix of properties will ensure uninterrupted cash flow as dips in income from assets in specific geographic markets or segments that suffer in a downturn are offset by assets in more resilient markets or segments.

The pandemic confirmed about CRE is that income may dip temporarily, but it never comes to a screeching halt. Individuals don’t suddenly stop needing shelter, and businesses don’t suddenly stop needing office or warehouse space overnight. Sticking with CRE long-term will reward you with above-market risk-adjusted returns over the long haul.

Diversifying across multiple property types in multiple geographic markets will ensure uninterrupted cash flow – even during short-term market blips.

In a recession, diversifying the Wall Street way can go very wrong. On the flip side, diversifying like the ultra-wealthy can go very right by sustaining your income through a rough patch for the market.

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