Delight Yourself with Diversity – My Favorite Idea

Delight Yourself with Diversity

Fruit and vegetables are one of our primary sources of vitamins and minerals, which the body needs to function well. For example, vitamin A helps to strengthen our immune system, vitamin B help us process energy from food, vitamin C helps to keep cells and tissues healthy, and vitamin D helps us maintain healthy teeth and bones.  The reason we need a diet based upon all the groups is that they all deliver different-but-vital nutritional benefits to our bodies.  And it’s the same way with portfolios too, especially when every asset class today seems more richly priced than usual.

Numerous studies have shown investor portfolios are woefully undiversified in several areas, including exposure to foreign stocks (see previous blog post "Investing Where It's Uncomfortable"), investment styles (value vs. growth stocks), and size of firm (small vs. large companies).  

While diversification has multiple benefits, including potentially higher returns, its primary benefit is reducing volatility.  This matters because our ability to deliver reliable investment outcomes is highly dependent on achieving the highest risk-adjusted returns possible.

Every dog has its day in the sun and the investment world is no different.  Over time, higher returns have historically been achieved by exposing a portfolio to various “factors” that have provided excess returns.  These include smaller companies, value stocks, and more profitable firms.  Diversification helps because you can expose your entire portfolio to a plethora of these factors, instead of just one.

We strongly believe these “dimensions” of higher returns can be captured more reliably over longer periods of time and a simple example will illustrate this point.  According to Dimensional Funds, the Fama/French US Value Index has outperformed its US Growth counterpart by nearly 3.5% annually going all the way back to 1928.  However, this relative price premium doesn’t show up like clockwork each year.  In any 1-year period, the odds are just 63% that value stocks will outperform growth stocks (over 10 years, the odds rise to 85%).  This illustrates the importance of patience in realizing the benefits of diversification.

As you might suspect, if you were to buy just ONE value stock, you probably wouldn’t find it useful to pencil in outperformance of 3.5% each year.  It historically has occurred most often when you buy the WHOLE basket, and it only appears over time. 
 
Which brings us to our next point (and the chart below).  If you hold a portfolio of 1,000 names instead of 50, and tilt your portfolio towards these dimensions of higher returns, the historical frequency of outperformance approaches 96% over a ten-year period!  I’d take those odds any day.  How about your typical bottoms-up, fundamentals-focused portfolio manager who holds just 50 stocks?  Not a chance, even with a sound methodology for buying stocks that tend to reward investors over time.  Let’s be honest – at just 56% over a one-year period, even the most focused investor would probably be tempted to bail before the full ten years. 

The Importance of Diversification Slide

Here’s the simple reason why diversification matters: it is not systematically possible to predict which securities are going to do best year in and year out.  This pattern illustrates the importance of pursuing dimensional premiums in a broadly diversified way rather than individual stock selection.  After all, not all stocks have the same performance and it is usually a subset of the stocks that drives the realized premiums over any period.  

Since it is impossible to predict which stocks will do well or poorly, a concentrated portfolio can produce extremely good or inferior performance, exposing investors to much greater uncertainty around the investment outcomes.  In contrast, being broadly diversified puts investors in the best position to reliably capture higher returns from the best performers, which more than offsets their exposure to the weakest names.

If you don’t believe us, consider the empirical findings of a recent study of stock market returns by Hendrik Bessembinder, a finance professor at the W.P. Carey School of Business at Arizona State University: most stocks aren’t good investments.  Yes, that’s right.  Most stocks fail to beat the returns of one-month treasury bills.  Only a handful of stocks are extraordinary performers.  In fact, just 4% of all publicly traded stocks account for all the net worth earned by investors in the stock market since 1926.  

So just to make it very clear, the real danger is omitting the big winners from your portfolio.  If only one in twenty-five companies are responsible for generating all the stock market gains, the risk is that you don’t own the future Amazon.  Or even if you do buy it in a concentrated portfolio, you lack the patience to hold on through the inevitable 80%+ swoons in market price.  The best thing about a diversified portfolio is that you own winners…every one of them.  And the value created by the winners dwarf the amounts destroyed by the losers. 
 
On the Eve of Thanksgiving, that’s certainly something investors can be thankful for!