Why nobody likes diversification

I work as an investment manager, and a few years ago I had a boss called James (not his real name). His job was mainly portfolio construction, but he occasionally took client meetings and provided portfolio updates to some high net-worth individuals alongside the relationship managers. He had a vast repertoire of favourite sayings that he’d come up with himself, but one of his all-time favourites was, “This job would be so much easier if we didn’t have clients”.

Now, obviously if we didn’t have clients the business would go bust. He was making that point that clients made his life difficult because they were never satisfied.

James and I used to get clients ring up when markets were doing well. They’d complain their portfolios “weren’t up as much as FTSE” (or any other index of their choice), which was inevitably part and parcel of the strategy they’d signed up for – usually their portfolio took far less risk.

When markets were falling, those same clients would ring up again. Only this time, they’d complain about losing money, even though they were doing substantially better than the index they were comparing against when markets were rising.

We all want relative outperformance when markets are rising, but to not lose money in absolute terms when the markets are falling.

Sadly this requires 100% equity-like exposure on the upside, and 100% bond-like exposure on the downside. This is obviously impossible from a portfolio construction point of view, but it doesn’t stop us from feeling the pain of either underperforming when the markets are going up or losing money when the markets are going down.

This is the first reason why investors don’t like diversification.

1) It’s painful

If you have a diversified portfolio, you will always be underperforming something. That’s literally the point of diversification. If all parts of your portfolio were going up at the same time, then the chances are high that they’ll all go down at the same time, too. For diversification to reduce losses on the downside, where we need it to work, it must also reduce gains on the upside.

Given parts of your portfolio will always be underperforming, the portfolio as a whole will be dragged down by these underperforming assets, so itself will always be underperforming something.

In the words of Brian Portnoy, “Diversification means always having to say you’re sorry”.

A great example of this is provided by Blackrock, who show the performance of a diversified portfolio over an 18-year period from 2000-2018:

Source: Blackrock

The chart shows that throughout the period, the diversified portfolio of 60% stocks and 40% bonds is either losing money in absolute terms or returning less than the S&P. Relative to the S&P, it underperformed by 100% over 8 years in 2009-2017. I don’t think anyone would be happy with a strategy that underperforms by that much for 8 years.

The portfolio never outperformed in rising markets or avoided losing money in falling markets.

Yet despite always either underperforming or losing money, after the full 18-year period, the diversified portfolio outperformed the S&P.

This is the power of diversification.

Yes, diversification means you’re reducing the upside. But you’re also reducing the downside. As we’ve seen in this article, Why is diversification so important?, losses are disproportionately harmful for portfolios. By diversifying, you’re reducing your portfolio’s volatility tax and helping to avoid the few big drawdowns which destroy wealth. 

A diversified portfolio will never be the best in hindsight, but it will also never be the worst. Investing is a loser’s game, and the only way to win is to avoid making stupid mistakes like not being diversified. Not being stupid beats being smart.

The great Jack Bogle, founder of fund management giant Vanguard, talked about his own portfolio – noting that he was about 50% invested in stocks, and 50% in bonds.

His comment was, “I spend half my time worrying about why I have so much in stocks and the other half worrying about why I have so little in stocks.”

2) Getting rich quick

I’ve been banging the drum on this blog about the benefits of diversification, and while we all know that diversification is good for us, nobody really wants to diversify.

What most investors really want (including me) is that one investment that’ll make them rich. Deep down, we all want the benefits of investing (the high returns) with none of the downsides (the time and the risk).

It’s why so many people continue to pick stocks, despite the huge amount of evidence showing the odds are against them. It’s why people continue to fall for financial scams, and it’s why people continue paying over the odds for people to manage their money on the promise of outsized returns.

In our hearts, we all want to make easy money. This makes it much easier for others to convince us that it can be done. That’s why “This one stock which I’ve got inside knowledge on” will always make for a more convincing story than “This sensible, cheap, diversified portfolio”.

It’s relevant for dieting too – or really anything which requires short-term sacrifice for long-term reward. Diet fads will continue to proliferate for as long as there’s the allure of losing weight without having to change your diet or do more exercise. Diets promise all the reward with none of the downside. We all know that long-term weight loss is all about eating healthier and doing more exercise, just as we know that long-term wealth generation requires staying diversified. Yet diet fads are still everywhere.

Investing isn’t about getting rich quick. As Warren Buffett famously said, “Successful Investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant.”

3) Survivorship bias

Here’s a list of the top 10 richest people in the world:

Source: Forbes

The first thing to notice is that there’s one thing every single one of these 10 people has in common: they all acquired their wealth through concentrated equity ownership.

Another thing to notice is that there are no film stars, pop stars, or footballers.

The richest film star in the world is Shah Rukh Khan – aka “The King of Bollywood” – who has a net worth of $600m.

The richest footballer in the world is Cristiano Ronaldo, with a net worth of $450m.

The richest musician in the world is Herb Alpert, with a net worth of $850m.

But even these three pale in comparison to the ten wealthiest:

Sources: Forbes and WealthyGorilla

The scale of difference is staggering. Cristiano Ronaldo is a held up around the world as a ludicrously wealthy footballer, living the life that most kids dream of. But Jeff Bezos is 300 times richer than Cristiano Ronaldo.

Even with the huge disparity, much of the wealth of the non-businesspeople has been generated through their subsequent business ventures. Shah Rukh Khan owns plenty of property, a film production company, and an Indian cricket team. Cristiano Ronaldo owns his own luxury ‘CR7’ label, as well as earning plenty from his Nike sponsorship, social media ‘influencer’ earnings, and product endorsements. Herb Alpert owned a successful record label before selling it for $500m in 1987.

Even these non-businesspeople generated much of their net worth through equity ownership.

Looking at these fabulously wealthy people, it’s easy to think that the best way to get rich is through concentrated equity ownership. The business you build up your equity stake in doesn’t even have to come close to Amazon’s scale, but a large stake in a successful business – especially one which subsequently gets acquired – is often thought of as reasonable path to becoming wealthy. “Concentrate to build wealth, diversify to preserve wealth”, as the saying goes.

And that’s an easy way to justify not being diversified. None of the richest people in the world got that way through holding a diversified portfolio of equities for 40 years. They built their own businesses, often from scratch, and either continue to run them or sold them for huge sums.

But we only ever hear about the success stories.

In reality, 90% of startups fail. 10% fail within the first year, and 70% fail within 2-5 years.

Even if you beat the odds and create a successful business, there’s no guarantees of staying wealthy. For the successful entrepreneur, even becoming a billionaire doesn’t prevent you from losing it all. Sure, it makes it more difficult, but it’s still very possible.

Even after becoming wealthy, the statistics show that 70% of wealthy families lose their wealth by the second generation, and 90% do so by the third generation.

Despite all this, it’s extremely common for employees and small business owners to build up extremely concentrated stakes in their employer or business.

I knew one woman who used to work for one of the major UK high-street banks. Over the many years she worked there, she built up a substantial stake in her employer. She contributed the maximum possible to the employee share scheme every month, and took all her bonuses in company shares. Over time, she built up a huge share of her personal wealth in the bank, and was relying on it for her retirement – the bank was “too big to fail”. Then 2008 happened, and the company’s shares fell by 95%. Her retirement plan was completely destroyed and she had to remain in work and dramatically change her expected lifestyle for when she did eventually retire.

Concentration can build significant wealth, but it can also destroy it, too.

I’m not trying to discourage anyone from starting their own business or buying shares in their employer. All I’m trying to do is highlight that when we’re looking at those who became mega-rich through concentrated equity positions, we’re only looking at part of the picture. As Nassim Nicholas Taleb would say, “Beware the silent evidence.”

The reality is that most people won’t start successful businesses. For most people, the easiest way to build wealth is to hold a sensible, cheap, diversified portfolio for multiple decades. If building a multi-million pound portfolio can be done by a legal secretary, a carpenter, a gas station attendant, and a flight attendant, it can be done by anyone.

A diversified portfolio also comes with the benefits of not being high pressure, not being stressful, not taking any time to manage, and not putting any strains on relationships – all of which come with concentrated equity positions.

 Conclusion

• A well-diversified portfolio will always be under-performing something.

• It will never be the best performer, but it will never be the worst performer either. Given the destructive effect of losses on a portfolio, mitigating losses through diversification is key for long-term wealth building.

• Investing isn’t about getting rich quick. “If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring.”- George Soros

• Most extremely wealthy people became wealthy through concentrated equity positions. But we can’t forget about the countless others who took similar routes and failed.

• For those who don’t want to run the risks of concentration, a diversified portfolio is a much safer route to wealth. It also comes with the benefits of not being high pressure, not being stressful, not taking any time to manage, and not putting any strains on relationships.

• If building a multi-million pound portfolio can be done by a legal secretary, a carpenter, a gas station attendant, and a flight attendant, it can be done by anyone.