68. Your Investment Approach: Diversification
Your Investment Approach: Diversification
Some very influential people think that "diversification is for idiots". In this episode I cover why I think diversification is actually critical to your investment approach.
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Transcript:
Hello, and welcome back to the Canadian Money Roadmap Podcast. I'm your host, Evan Neufeld. Today we are continuing with our series on building your own investment approach, and this episode is focusing on diversification.
When it comes to investing, one of the classic tips or pieces of advice that one would give is to not put all your eggs in one basket. What does that actually mean? Well, that's referring to the concept of diversification and on this episode, we are going to be talking about whether you want to build your portfolio with an approach towards diversification or concentration. So if the main idea that many of you have heard before when it comes to investing, is not putting all your eggs in one basket, how come certain people, including Warren Buffett and Mark Cuban, I'm going to show a few clips from interviews with, with these two gentlemen, why would they say that diversification isn't a great idea. “We like to put a lot of money in things that we feel strongly about and that gets back to the diversification question. We think diversification is, as practiced generally, makes very little sense for anyone that knows what they're doing. Diversification is a protection against ignorance. I mean, if you want to make sure that nothing bad happens to you relative to the market, you own everything. There's nothing wrong with that. I mean, that, that is a perfectly sound approach for somebody who does not feel they know how to analyze businesses, if you know how to analyze businesses and value businesses, it's crazy to own 50 stocks or 40 stocks or 30 stocks, probably.” So that was Warren Buffett from many years ago talking in a seminar at the Berkshire Hathaway event. discussing his thoughts on diversification. Now let's put that one into context before we move on to Mark Cuban here. So Warren Buffet, along with Charlie Munger run the vast majority of the investment decisions being made at Berkshire Hathaway and Berkshire Hathaway's, a conglomerate, so they own shares in many other companies. They don't necessarily do a whole lot of business production themselves, but they own pieces of other companies and together Berkshire Hathaway is kind of like an amalgamation of it. You can almost think of it kind of like a mutual fund because their portfolio is comprised largely of other publicly traded companies, including insurance companies, Apple, they're one of the largest shareholders of Apple anyways, his role at Berkshire Hathaway is to maximize shareholder return. His role is not to get average S&P 500 type returns. That is not why he's there. That is not why Berkshire Hathaway exists. So in his mind and in his approach, diversification isn't necessarily a great play, and his experience as an investor would lead him to believe that by simply evaluating a business upfront, you can actually pick the winners. And this interview was from many years ago and up until that point, and even now, he has done an exceptional job at doing that, largely because he's been able to hold these companies for so much longer than the average person has been investing at all. But anyways, just a little bit of context in that regard. But here's Mark Cuban and what his thoughts are:
“When I started trading stocks in the early nineties, after I sold my first company, you know, you could understand different elements of the market better than the professionals. So I can understand. You know, new technology from Wellfleet and Synoptics and all these old technology companies better than the traders. Today, there's so much money in these huge hedge funds and it then they have such professional research and in-depth research. There really aren't any advantages for the individual traders. And so my approach has always been, unless I know something specific, put it in cash. And so what are you investing in? What are the areas that you feel, you know? What I did in 2008 and 2009, I put everything into MLPs and m rates mortgage backed security ones that I thought were the better companies and I just piled it in, and I also piled into Australian bonds because I thought the economy was good next to China. It was my way playing China. So you make one way bets. This isn't portfolio balancing you're talking about No, the all that asset management, you know, diversification, that's for idiots, right? Because you can't diversify enough to know what you're doing. Right. I mean, I did my homework on Australia, right? I did my homework on the Emory's, I did my homework on MLPs and their pricing had just gotten crushed.” So that interview with Mark Cuban was with the Wall Street Journal, and you should see how uncomfortable the interviewer looks, he is just absolutely squirming in his seat when Mark said that diversification is for idiots. In his world, what he's describing, he's absolutely correct. Because what he's describing is a world of trading and trying to outperform hedge funds and professionals by trading yourself. The average investor should not be doing this, but in Mark's world, he's got enough money to play. That if he wants to try to do that, and he thinks him doing homework is better than the armies of analysts and all the other professionals who've also done their homework, by the way, it's a little naive to think that he's doing more homework than them. But if you're trying to make outsized returns greater than the index and greater than all the other professionals in aggregate, you have to make singular outsized bets. And that has nothing to do with diversification. So when it comes to building your own investment portfolio or building your investment approach, you have to come to terms with yourself and really figure out what is your objective in the first place in building this investment portfolio?
Number one, are you trying to actually generate the greatest investment return possible? Or are you trying to create the smallest dispersion of results while meeting your investment goals? That's a mouthful, and no one would ever say that, but I'd probably argue that most of you are in this camp.
As an investment advisor, as a financial planner, my goal for my clients is not home runs or strikeouts. Looking at Aaron Judge for the New York Yankees, he was the home run leader last year. He is also top 10 in strikeouts. There's a number of others that that would fall under that category. They had a lot of home runs, but they're a lot of swings and misses. By having a really highly concentrated portfolio with very few individual stocks, you really expose yourself to both of those potential outcomes. Diversification is like increasing the odds of average success by hitting for singles and doubles and generating runs to use another baseball metaphor, and that can be a really great way to build wealth over the long term. No, you're probably not going to get Lamborghini private jet wealthy by investing in a diversified portfolio by using the stock market to your advantage to help you meet your investing goals is a great way to do that. Just don't be confused about what you're actually doing. So participating in the stock market is generally provided a great opportunity for significant investment returns over time. However, that's not always the case for all investors or even average investors because too many people see the stock market in a way that Warren Buffet is describing who's in a very different situation and the way that Mark Cuban is investing, who's also in a very different situation. And most people see the stock market that way is a way to create generational wealth, beating some hypothetical index and becoming wealthy beyond your wildest dreams. My argument would be that investing in the stock market should not include these as your primary objectives. When you diversify, you are reducing the potential for catastrophic failure in any one company. So let's just use a hypothetical here. One big famous company that went to Zero recently, FTX, let's say it was publicly traded. It wasn't, but let's say It was publicly traded and you could own their stock. versus a big, boring company that's been around a long time like Coca Cola. Well, if you owned just FDX and it went to zero, you would've lost all of your money. You'd have negative a hundred percent return. However, investing in Coca-Cola, well they've been around for well over a hundred years, your investment returns would be largely positive. That has been one of the best performing companies over its life time. So owning those two companies, for example, so if you own FDX, your money goes to zero. If you own Coke, you're perhaps generationally wealthy. If you own two of them, however, your experience is somewhere in between. Now, what if you loop in something like Apple or Nike, Costco, Lululemon, some of these other companies that you've heard of before that have performed decently well recently but haven't gone to zero.
Once you start looping in other companies into a portfolio, you essentially eliminate the risk of any singular company going bankrupt. This is what we call firm risk or company risk and diversifying. So not putting all your eggs in one basket, eliminates your risk of any one company going to zero. Now, I'll have to think back a number of years back to stock analysis class back in university.
I'm pretty sure that number is right around 30, that the number of stocks that you invest in statistically eliminates the risk of any one of them going to zero. It's probably in that, that ballpark of both 30 stocks. However, diversification can provide other benefits beyond just avoiding single company bankruptcy risk. What if all the companies that you own are all tech companies and perhaps there's something political that comes into play, or even just that sector underperforms for a long period of time, owning companies in other sectors would be able to balance out your performance over time. What about countries? There's nothing inherent about a country that allows it to perform well over time, but there's certain, certain aspects of different countries that will lead to different amounts of performance. And so most people have been enamored with investing in the US recently because, US stocks have provided great returns over the last decade or so, but between 2000 and 2009, there was a 10 year period of time where the US stock market returns 0% on average. Well, that's not very good. What about some other countries? So investing in other countries at that same time would've been able to help diversify against lost decades, and that's happened in other countries besides just the US. What about even just the two main asset classes or two large asset classes that you're familiar with? Stocks and bonds. Do stocks outperform every single year? No. What about having some bonds in there so that When you add bonds, it decreases your asset class risk through diversification. Now, this one's a little bit more complicated, but factor risk. So over the last 10 years or so when interest rates have been virtually zero, growth stocks, which I'm going to talk about in another episode, have benefited from a very low interest rate environment because those companies could grow for virtually nothing because they could borrow money for very cheap.
And so in that type of environment, value stocks hadn't done very well at all. And those two factors, so the value factor in didn't perform very well, but other factors did. And so by only investing in one factor or one asset class, or one country, or one sector or one company, you create a portfolio that has a very wide dispersion of potential returns where between generational wealth and nothing at all. But once you start looping in some additional companies, some additional sectors, some additional countries, other asset classes, other factors, then you increase your diversification and you shrink your potential dispersion of results while hopefully still meeting your investment goals.
So I'm going to talk about an academic study that was done back in 2018, and depending on where you land on this, as a financial planner, I'm obviously pointing you towards the path of diversification, but depending on how you interpret the results of this study it'll encourage you to either diversify or build a concentrated portfolio.
So this study was titled Do Stocks outperformed Treasury Bills, and those are short term bonds in the US. So do stocks, outperformed treasury bills. This is from Hendrick Bessembinder. I hope I'm pronouncing that correct. And throughout some of the research in here, there's a variety of outcomes that he was hoping to achieve. But one of the most interesting was his findings on how few stocks have actually contributed to the total return of the stock market.
So his data goes back to 1926 and went up to 2016 when he was doing the research. So there's 90 years of data there. And during that period of time there was, this was just in the US but there was 25,300 companies that had issued stocks there at during that period. Some of them had gone to zero and many of them had done very well. So in 2016, he had assessed that the stock market was responsible for lifetime shareholder wealth creation of nearly 35 trillion dollars during those 90 years. However, just five firms, and he names them here. So Exxon mobile, Apple, Microsoft, General Electric and International Business Machines or ibm. Those five companies accounted for 10% of the total wealth creation of the entire stock market over the last 90 years.
Now the top 90 performing companies, so that's one third of 1% of the companies that were listed during that period of time, accounted for half of the wealth creation. And then the 1092 top performing companies, so slightly more than 4% of the total, account for all of the net wealth creation. That is unbelievable.
So that means that 96% of companies whose common stock had appeared in this dataset collectively generate lifetime dollar gains that matched the gains on one month treasury bills. So his point here was that if one month treasury bills are kind of deemed to be the risk free rate, investing in stocks should hopefully provide a return above and beyond that. But he found that 96% of companies collectively did not achieve that. Okay, so now let's put you in the world of Warren Buffett and Mark Cuban for a second here. And you say, okay, well I'm not going to do this stupid diversification stuff. I'm going to own a very concentrated portfolio and I'm going to own it for a very long period of time, and that's how I'm going to make generational wealth. Well, if history is a guide, only 4% of companies that have existed during the last 90 years were able to do that. So are you looking at the stock market today and saying, I know which companies those are going to be in the future? That's crazy. Like if you think you can reasonably do that and just own those ones, just own the good ones. No, at some level you have to assume some level of diversification I think.
So the, the argument for diversification here, of course, is that, okay, well if you own the entire market, you've done really, really well. And so the best part of that is you already own the 4% that's going to carry the weight for everybody else. You're going to own all the companies that end up going to zero all of them, but you're also going to own all the other ones that carry all of the weight for building returns over time. That's kind of the main idea of index investing, is that owning the entire market is the most reliable way to actually get the outsized returns that stocks provide. So back to the objective in building an investment portfolio, if you think that your job with investing is to create the greatest investment return possible, you should not be diversifying. But you should also be realistic that, the odds are highly stacked against you, that you're going to be able to do it. But if you have the objective, creating the smallest dispersion of results while meeting your investment goals. I would say a diversified portfolio is a great way to go.
Now, as I mentioned before with single companies, single countries, single sectors. You can still have versions of diversification within there. So you could have an All Canada portfolio that has a bunch of different companies in it and a bunch of different sectors, but at the same time, it's still all Canada. There's a bunch of different layers of diversification there. So you might start thinking, okay, is there the potential risk for over diversification? I would say within those factors, I would say no single company, risk sector, risk countries, asset class factors, I don't think that you can be over diversified, but the thing that I have seen many times that can be called over diversification would be owning multiple index funds that track the same index.
So in the last week's episode, I talked about VEQT and XEQT. If you are splitting your money between those two ETFs, that is, in my opinion, over diversification because you have two funds, you're trying to diversify against each other, but they're both trying to do the same thing. That's not diversification in my mind. That’s just over complicating things. If you're going to do that approach, just pick one. You're not going to get any additional diversification benefits, even though the potential returns will be slightly different.
Another thing that you can look for in terms of diversification benefits is correlations. So just comparing two potential investments or index funds here, if you own an s & p 500 index fund and a US Total Market Index fund, the correlation between those two will be extremely high, likely close to 98%. And the main reason for that is because both of them will be what we call market cap weighted.
So they will own the most of the largest companies. And in the US the biggest companies are huge. And so even though one of those funds technically owns some mid and small cap companies, because they're so small, just using a market cap weighted index doesn't necessarily provide any diversification benefits in a meaningful way, in my opinion, between those two. So owning an All cap US fund and an s & p 500 fund, in my opinion, that's not really diversification.
So taking a look at your different holdings, like even in Canada here, if you have a TSX 60 fund that's going to own the 60 largest companies in Canada, and if you pair that with a Canadian dividend fund, guess what? The largest companies in Canada are, they’re largely the biggest dividend paying stocks. So that's going to be a lot of the banks, telecoms, oil and gas, and those companies are all the largest dividend payers. So there's going to be tons of overlap there. So within diversification, I would also introduce the idea of correlation. So if you're going to own something, it has to be different enough for you to own it and provide an experience that is differently correlated than the things you already own.
Same thing goes in the actively managed space. So even though actively managed funds will turn over relatively often, and it's tough to really stay on top of it, most portfolio managers for active funds will have some sort of factor bias. So they'd say, oh, I'm a growth investor, I'm a value investor, and they'll pick and choose within that. If you have multiple actively managed funds with similar factor exposure, I would argue that's not really providing much of a diversification benefit and you'd be better off building a portfolio based around the factors that your active managers represent than by doubling up on multiple funds that are trying to do a very similar type of strategy.
One thing I want to encourage you with when you're building your portfolio is that you can be diversified and simple. Make sure you understand what the underlying holdings are of any ETFs or mutual funds that you own, because even owning a single fund, a single ETF can be a really, really well diversified approach that's very, very simple and just over complicating things by adding additional funds or ETFs or even additional individual stock holdings on top will likely only add confusion, complication, cost and underperformance. Is that compelling, simple is great, but diversified and simple is better.
I like Mark Cuban and a lot of things he says. I like watching him on Shark Tank. I like Warren Buffet. He says a lot of very interesting things, and he is been very successful in his life. But when it comes to diversification, you're not Warren Buffet and you're not Mark Cuban, and your investment priorities are likely very, very different than theirs. So I would encourage you this is the one episode so far in this series where I'm trying to steer you in one direction, or another. I would argue that you as the listener should aim towards building a well diversified portfolio with low correlations between the different investments that you have or keeping things really simple with minimal funds.
Thanks for listening to this episode of the Canadian Money Roadmap Podcast. Any rates of return or investments discussed are historical or hypothetical, and are intended to be used for educational purposes only. You should always consult with your financial, legal, and tax advisors before making changes to your financial plan. Evan Neufeld is a Certified Financial Planner and registered investment fund advisor. Mutual funds and ETFs are provided by Sterling Mutuals Inc.