Written by Kyle J Christensen, CFP, May 8, 2023
We are often told by financial institutions, that we should “diversify” our investments. Supposedly, this is how a person can reduce their risk of having a major loss when the economy goes through a downturn, a recession, or even a depression. And because most people are generally risk-averse (we pay more for a safer car, we go into work early to avoid traffic – to avoid accidents or to avoid being late, we will pay more for a medical solution that is less risky, etc), the idea of diversification sounds good.
The idea behind diversification is that if we spread our money out in a bunch of different types of investments, in different sectors of the economy, when something goes wrong, we won’t “have all of our eggs in one basket”. Supposedly, we won’t be hurt as badly. Is this a strategy that really works, or is it just effective marketing?
To be clear, the people and institutions promoting the idea of diversification are not really talking about diversification within different asset classes. They are really only talking about diversifying within the arena of “paper assets” (stocks, bonds, mutual funds, etc). Only within the things they sell. They are not saying you should have 1/4 of your investment assets in stocks/bonds/mutual funds. 1/4 in your own business. 1/4 in cattle and chickens. 1/4 in real estate investments. No, they (the financial institutions and most of the financial planning world) are only talking about Wall Street investments. How has the idea of diversification within Wall Street worked out in real life?
In 2008-09 we had a major recession (some call it “The Great Recession”). The S&P 500 is a benchmark index which is made up of a weighted value of each of the largest publicly owned companies in the United States. So, companies like Coca-Cola, Disney, Apple, Microsoft, Berkshire Hathaway, Exxon Mobil, are in the S&P 500. It’s arguably the index that best represents the U.S. Economy as a whole. Based on the idea of diversification, the S&P 500 should have been pretty well protected from the downturn. Sure, some of the stocks should have tanked (specifically the financial stocks – i.e. Bank of America and Wells Fargo, among others), but others should have done well, possibly better than ever, during that same time. What was the result? The S&P 500 closed at a high of 1,557.59 on Oct. 1, 2007. At the bottom, on March 2, 2009, the S&P 500 closed at 683.38 pts. That was a total decline of 56.13%. In other words, people who were “well-diversified” lost more than half of their retirement account values. It doesn’t seem that they were very well protected. The outcomes were very similar in every other recession or major downturn in the market over the history of the market. It didn’t seem to matter whether a person was diversified or not. In fact, being diversified may have actually guaranteed a person lost money.
Now, to some degree, could someone argue that being in the index, which is massively diversified within the stock market, would have been better than being concentrated in, say, Countrywide Mortgage stock (the largest U.S. mortgage lender at the time)? Countrywide, which was one of the biggest perpetrators of leading the country into the 2008 crisis, went from its all-time high of $45.03 per share price to barely over a dollar per share, before being purchased by Bank of America. Countrywide, as a stock, doesn’t exist anymore. So, a person could have lost everything, if they were only invested in Countrywide during that time. Situations like this seem to lend a little bit of support to the idea of spreading out for people who are investing in the stock market, but it’s really more of a strategy for gamblers, not investors. The real lesson for this may be that it’s really just an example of why you shouldn’t concentrate your investments into one thing where you have little or no knowledge of and little or no control.
In fact, this this is what Warren Buffett says about diversification: “If investing is your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your first choice.” Mark Cuban says “Diversification is for idiots” (I’ve never quoted Mark Cuban before, nor will I again – just not a fan, sorry – but he is a very successful businessman and investor and his statement is valuable regarding diversification). Do they have a valid point?
Let’s just think about the idea of diversification for just a moment. Try to forget everything you’ve heard from the financial world regarding this topic, and decide for yourself if it even makes sense. Is diversification is the best way to lower risk from an investment standpoint. Consider for just a moment, that maybe, just maybe, diversification might simply be a marketing tool to get people to invest in more and more things that they know less and less about, giving up more and more control to the institutions selling those investments. Ultimately, isn’t that what financial institutions want? Don’t they want more control of your money?
What’s the opposite of diversification? It is concentration. It is focus. It is specialization. One evening at a dinner, Bill Gates, Sr. asked Warren Buffett and his son Bill Gates, Jr (Founder of Microsoft) “What factor did people feel was the most important in getting to where they’d gotten in life?”, they both answered that it was “focus”. It wasn’t diversification. It was focus.
If you think it through, I believe you will come to the same conclusion. The path to success in life is not diversified attention. It is focused attention. It is not general knowledge about a lot of different topics (unless you are a contestant on Who Wants to Be a Millionnaire?). It is deep knowledge on a smaller number of topics. It is not the general medicine practitioner that makes the most. It is the specialist.
Knowledge is actually what reduces risk, in almost any area of life that you can think of. It is lack of knowledge that creates risk. Robert Kiyosaki says, “If the investor is uneducated, anything he or she invests in will be risky.”
In saying all of this, I am not suggesting that you or I can invest in anything and be exposed to no risk. All investments by nature entail some level of risk. However, it is a continuum of risk. It’s rarely 100% risk of loss or 0% risk of loss. Consider this extreme: Assuming you aren’t a heart surgeon, how risky would it be for you to perform heart surgery on someone versus an experienced heart surgeon? What’s the difference? Why is the one risky and the other isn’t as risky? Consider the investment of time, observation, education, and practice for the heart surgeon in an effort to reduce risk.
We are constantly told that “risk equals rate of return.” In other words, the more risk we are willing to take, the greater the potential return. This is flat out false. As another example, consider the level of risk a dentist might be taking on by investing in the expansion of his/her office space and number of chairs, if the dentist has a consistent demand of new patients that exceeds his/her capacity. What is the level of risk? Again, risk is related to the level of knowledge. It isn’t related to rate of return. Risk has almost nothing to do with rate of return. If I believed “risk equals return”, I would have a tendency to invest in a bunch of things that I have no knowledge in (which is what most people are doing). Risk, by definition, is the propensity for loss. It is not defined as the propensity for gains.
A central theme in the classic self-help book, Think and Grow Rich, is that of specialized knowledge. Author, Napoleon Hill, states: “Before you can be sure of your ability to transmute desire into its monetary equivalent, you will require specialized knowledge of the service, merchandise, or profession which you intend to offer in return for fortune.”
Let me translate that into today’s language. Before a person can obtain the fortune they seek, they must obtain the knowledge that is required for whatever service or product they are going to offer in return for the fortune.
Someone might respond to that by saying, “What if I don’t have the time to learn in addition to what I do for my job?” In other words, “What’s the investment route for people who won’t invest time to learn?” This points to a fundamental misunderstanding of what investing is. Investing is learning. Investing is becoming. The word invest means “to commit money in order to earn a financial return” (Merriam-Webster). The word earn is a keyword in that definition. Earn means “to receive as return for effort and especially for work done or services rendered” (Merriam-Webster). Investing is earning.
What is it called when someone puts money into something and has little or no knowledge and little or no control over the outcome? Look up the definition of the words speculate and gamble. I believe you’ll find those words are more closely in line with the idea of expecting a return on something where there is no knowledge and no control.
Where are the examples we have in society where people invested in a bunch of different things that they knew little about, gave up control and influence of the outcome for decades, and somehow that worked out fantastically well for them? By contrast, think of every single instance where someone did become financially free. Did they do it by becoming great at something? Did they do it by specializing in their knowledge and skills? I can’t think of any situation where that wasn’t the case. I know of no one, not in 24+ years of doing financial planning, that became financially free by diversifying in the stock market. During that same timeframe, I have seen countless individuals who have tried to follow the conventional wisdom of diversification and have had no better than mediocre outcomes. Never once have they become financially free as a result. That is not to say that I haven’t known anyone who has a lot of money who invested in diverse investments in the stock market. I’ve met some over the years that have a lot of money invested in the stock market (millions), but that’s almost never where the money was created. But in no circumstance have I seen a situation where a person “saved” money into a diversified portfolio of stocks, bonds, and mutual funds (in our outside of retirement plans) that could they come close to replacing that person’s entire income. It simply does not happen. In almost every case where someone was able to “retire” and replace their income using the money they have invested in the stock market, it’s because they had (at least to begin their retirement) a highly concentrated amount of their money in one stock (usually their employer’s stock – obtain through bonus/restricted stock units). Outside of that kind of scenario, I’ve never seen it throughout my career. The reason? Because it isn’t diversification that creates wealth and financial freedom, it is specialization.
I encourage you to read and learn more about the importance of focused and specialized knowledge, as compared to diversified knowledge and lack of focus. Read biographies and autobiographies from highly successful people. See how they did it. We can learn from them. Becoming financially free has ALWAYS required specialized knowledge, as does remaining that way. You do not have to gamble in order to succeed financially. In fact, I can say that eventually and predictably, the gambler loses. “The house always wins.” Let’s not depend on the benevolence of “the house” or just plain luck. Let’s rely on our ability to learn and grow, and invest in the things we can influence and control.
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Here are a few great books about some highly successful people that I’ve read and would recommend (Name of the person the book is about):
– The Snowball (Warren Buffett – Berkshire Hathaway)
– Barefoot to Billionaire (Jon Huntsman, Sr – Huntsman Chemical Corp)
– More than a Hobby (David Green – Hobby Lobby)
– Driven (Larry H. Miller – Larry H. Miller Corp)
– The Lifestyle Investor (Justin Donald – Lion Investor Group)
– Henry Ford: My Life My Work (Henry Ford)
– Principles: Life and Work (Ray Dalio, Bridgewater and Associates)
– Winning (Jack Welch – GE)
– Wooden on Leadership (John Wooden – UCLA)
