Brief Public Service Announcement: Common Misconception of Diversification

Executive Summary

Diversification has very little to do with how many stocks, mutual funds and ETFs are in your portfolio. Rather, diversification is about the correlations between assets in your portfolio.

​Common Misconception

I’ve had prospects come in to our intro meeting with statements in hand. Those statements show a plethora of various funds, individual stocks and/or individual bonds…usually with relatively small dollar amounts allocated to each.

Because there are so many securities listed on the statement the potential client thinks the investment strategy provided by their current advisor (or that they’ve built themselves) is complex, sophisticated and diversified.

Most often, the strategy is not sophisticated or diversified but just unnecessarily complex, redundant, expensive and directionless.

For example, they may have a bunch of mutual funds that all own many of the same stocks.

Or, many of the securities are just generally correlated thereby providing very little diversification benefit.

Meanwhile, we can build a more diversified, sophisticated, lower-cost portfolio with just a few holdings if we do it right.

Diversification is not about how many securities you own but the behavior of the securities you own in relation to each other through different market environments.

Having a portfolio of 100 securities that are mostly correlated means those 100 securities will move similarly with each other providing very little diversification / protection leaving you in a difficult position when the market is unfavorable for that group of securities.

Meanwhile, having even just TWO inversely correlated funds can provide far better diversification and protection than that portfolio of 100 different securities.

Understanding how different assets behave in relation to each other is the only way to build those guardrails I discussed in my recent commentary, “This Year Shows Why Risk Management Is So Important!”

My theory is that many advisors / brokers create unnecessary complexity to create the illusion that they’re providing a sophisticated, non-replicable approach to make clients feel like they’re getting a ton of value. When in fact, it’s just an unnecessarily complex, cumbersome, tax-inefficient and expensive portfolio.

It’s like when people use industry jargon and purposely speak over your head in order to sound smart but just leaves you frustrated. People who actually maintain a deep understanding of complex concepts are able to break those concepts down into simple, understandable tidbits. That is exactly my intent with these commentaries I write so often -> educate by breaking complex concepts down into more digestible tidbits.

Warren Buffett is one of the best at this. He is a very plain-spoken man where even folks with limited investment knowledge can generally grasp the points he’s making. It doesn’t mean he’s not smart or the concepts are not important… quite the contrary.

For example, we could talk about stock market valuations being extreme and there is a lot of hidden risk underlying the market that will likely cause severe losses and a lot of pain for ill-prepared investors when the mania ends…or Warren Buffett would say, “You see who’s swimming naked when the tide goes out.”

​Warren’s statement is likely going to stick with you forever to the point where you can repeat it to someone else.

Another one of my favorites from Mr. Buffett is, “Be greedy when others are fearful and fearful only when others are greedy.”

There he shares a critically important concept that could be expanded upon in an entire book but boils it down into a single sentence.

There is often beauty in simplicity. Hence the durability of the K.I.S.S. acronym.

Print Friendly, PDF & Email