Investing & Diversification: When Less is More

Dear Mr. Market: download

In many of our letters to you we discuss the ups and downs of the stock market. In doing so, we often times will share basic knowledge and investing reminders to our readers to help guide them. Without question, even a rookie investor will have learned the simple advice of diversifying their portfolio. “Do not put all your eggs in one basket!”

While that “advice” is intuitive and seems to make sense, it’s mainly regurgitated by every financial advisor because of one alarming reason. Yes, on one hand it’s with the intent of managing risk but part of the dark reality is because most people (pros included) don’t know what they’re doing. This last sentence may sound harsh but our job is to be candid and also share ideas and truths that you may need to know yet not always hear elsewhere.

If you stop reading this article right now do yourself a favor and at least spend seven minutes when you have more time. The seven minutes we want you to spend are watching the following clip of Warren Buffett and Charlie Munger. Click here to view it and learn their basic belief that most investors over diversify and are simply “protecting themselves from ignorance”.

Let us also preface this by saying that obviously neither you nor I are Warren Buffett. If he loses $100 million dollars today in the stock market, it does not change his dinner plans one bit this evening. That being said, when he buys a stock (and in doing so, one is technically a part owner of the company), he often literally buys the whole thing. The other extreme and caveat is that we’re not advising people to just buy three stocks and be done with it. Somewhere in the middle is the answer to the proper mix to mitigate risk but also not water down potential returns.

On our side of the desk we’ve seen hundreds of new portfolios over the years from some pretty high brow types of investment firms. It never ceases to amaze us how many advisors put their clients into so many positions. No joke…we analyzed a portfolio earlier this month from Bank of America Private Bank and they had the client in about 24 different mutual funds! Adding insult to injury, is that those funds were expensive and like so many others…underperformed their respective benchmarks. They claim to “specialize in complex financial needs of wealthy individuals & families, helping to manage & preserve wealth across generations” but from the looks of things, that portfolio is mainly making Bank of America wealthy by being unnecessarily complex.

One last example we recently saw was for a smaller portfolio that we transferred in from RBC Wealth Management. Within a moderate risk allocation the client owned 78 stocks all totaling about $200,000. Perhaps the constant buying and selling is intended to fool high net worth clients or give the perception that owning a lot of things must be smart? The reality is that these types of portfolios look like a garage sale of investments that have no real sophistication or design behind them.

Self directed investors are guilty of over-diversifying as well. Sure, at face value you have a ‘little bit of everything’ so there is always something that is hopefully going up. You also don’t own too much of any one particular investment so if you’re flat out wrong on one of your picks, you still have others to give you hope. Is that really a strategy though, or just another garage sale? Peter Lynch used to describe this as “deworsification”.

When this really can hurt is  in markets like the one we’re actually in right now. Our domestic market is being held up by a handful of five to six mega-cap names mainly in the tech sector (think Microsoft, Apple, Amazon, Alphabet/Google etc.) If one looks a bit deeper the overall breadth of the market has some ailing companies. To quickly illustrate this let’s take a quick peak at the best long-term performing asset class, Small-Cap Value.

We vividly recall the time period prior to 2017, which was the least volatile year in the history of the stock market, and how we researched which asset classes performed the best. From 1928 through 2016 the S&P 500 index returned about +9.7%, while small-cap value stocks grew about +13.5%. That’s quite a healthy delta but as of late this bet has not faired well at all. 2020 has been a real kick in the pants, and for small-cap value fans out there, you’re looking at -22.88%, even after this historic recovery rally we’ve seen off the March 23rd lows (versus -5.5% for the S&P 500).

Lastly, the majority of portfolios we look at could be beaten by owning two simple ETFs (exchange traded funds); one covering the domestic stock market like SPY and the other the aggregate bond market like BND. The reality is that as simple as this ‘secret sauce’ solution is…most investors won’t do this or stick to it. “Less is more” with many things in life, and even if you’re not a hoarder, your portfolio is sometimes begging for clear direction and confident bets as opposed to prayers and a shotgun approach of shooting at everything.

As we all dust ourselves off from this most recent bear market, the only folks who will come out of it stronger over the next cycle, are those who actually learned from it. Our portfolios are being streamlined a bit right now and wherever we need to eat crow or reevaluate why we’re hanging on to something…we will do exactly that. Just like an old pair of jeans that you can’t fit into anymore…sometimes it’s simply the right call to just get rid of them.

 

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