Remember 2008? That fall, I listened to podcast after podcast trying to make sense of the market crash, the bank bailouts and the emerging stimulus package. The uncertainty was unnerving. And many people shared my fear and anxiety.
The economy eventually turned around but not after some bumps in the road. It was my, and many of my peers’, first real experience of going through a big market downturn and recovery. Yet now 10 years later, that fear and anxiety have faded for me and many of my clients.
Today, many investors have forgotten the turmoil of that time. They have a different sense of security, safety and appetite for risk. Most recently, I’ve seen this in a few clients who want to keep a good majority of their wealth in their company stock. They work for big, stable companies. What’s the harm in that? I wanted to use this week’s post to talk about the importance of proper diversification and also provide some counter arguments as to when diversification may not be appropriate.
What is diversification anyway?
To understand diversification, most people use the metaphor of not putting all your eggs in one basket. If something happens to that basket, you’re out of luck. Diversification helps reduce the risk of something happening to your investment basket. In investing we talk about two main risks:
- Systemic risk: A general risk that every company faces such as inflation, interest rates or political instability. Because every company faces this risk it can’t be reduced by diversification.
- Unsystemic risk: Risk associated with specific company, industry, market or country. Because this risk affects specific businesses or markets, it can be offset by investing in business or markets that won’t be affected in the same way.
Another way to look at this is simply thinking about what happens if you only invest in one company. If you put all of your money in one company and it’s the next Google, (or is Google) you stand to make a lot of money. But if that company goes bankrupt, then you lose all your money.
Now think about what happens if that company is one of five companies in your portfolio. If it goes bankrupt, you only lose 20% of your wealth (which is still a good chunk). Diversification means spreading out your investments. If something happens to one of them, your overall portfolio doesn’t take as much of a hit.
Why it’s important
No one knows what the future holds. You can’t predict a tech bubble, a September 11th or an Enron (a seemingly strong company cooking its books). Even companies that look stable and secure can fail under unforeseen circumstances.
Behavioral scientists tell us that most investors (including professionals) are prone to overconfidence. They think they’re better than they are at picking winners. That confidence has only grown as we’ve gotten further away from the 2008 to 2009 financial crisis. Additionally, the SPIVA report shows us year after year, the vast majority of people that think they can predict or time the market are wrong. Despite these two scientifically proven truths, many of us have blinders on when it comes to risk. It’s even risker when your wealth and income are tied up in the same company.
I’m not saying risk is bad or that you shouldn’t take risk. Risk and reward are inextricably linked. The more risk you take, the higher your reward. You will have to take some risk in order to grow your money into an amount that will help you achieve your goals.
So it’s important to understand that while diversification limits some of your downside, it also limits your upside (more on this later). Diversification isn’t meant to eliminate risk. In fact, systemic risk isn’t reduced at all by diversification. It’s meant to balance the risk and reward calculation for your particular situation and investment goals.
In addition to looking at your overall goals, when building your portfolio strategy, I suggest taking into consideration your risk tolerance (your appetite for risk which depends a lot on genetics and life experience) and your risk capacity (your ability to recover and still meet your goals if something bad happens).
These two factors are separate, but they can interact in various ways. For instance, one of my clients who is comfortable with risk and has benefited from it (high risk tolerance) is now investing more cautiously because he has more to lose and less time to make up for those losses (lower risk capacity).
To build a diversified portfolio, you can look for investments across different types of assets (equities, fixed income, cash), different industries (financial, healthcare, technology, etc), different company sizes (small, medium, large), different types of assets (value, growth, blended) and different markets (domestic and foreign).
Simply put, you’re trying to create an investment basket that will compensate for some sectors of your portfolio falling by other sectors going up. Or even if they are going in the same direction, not to the same degree. In my opinion, the easiest way to do this is through index mutual funds or ETFs.
Again, the goal isn’t to increase performance, it’s to optimize the risk you’re taking for the return you need to achieve your goals and allowing you to sleep at night.
While diversification is important and your safest strategy for growing your wealth, it will likely never make you super rich. That’s because it limits your exposure to extremes in performance, both on the upside and the downside.
I read a great article by Michael Kitces on the way that diversifying too soon can limit your ability to accumulate wealth, He compared different retirement strategies to growing bushes and redwoods. He argues while those who take a bush approach to wealth building (allocating each bit of savings to a diversified portfolio) will have “enough,” those who want to generate more wealth and have a greater impact may need consider the redwood strategy, which involves concentrating your wealth into one investment for longer period and waiting to diversify.
Kitces points out, “you’ll likely never meet a bush saver with more than $5M of net worth, unless he/she had extraordinary high income to save in the first place.” He adds, “you’ll certainly never find someone with $10M who achieved it as a bush. To do that you need to be a redwood.”
You can see this theory in action by leafing through the Forbes list of the world’s wealthiest people. Most of them attained wealth by building companies and keeping their wealth in these companies for a long time. So if your goal is to be one of the wealthiest people in the world, working for someone else and putting your money in an index fund won’t get you there.
But growing redwoods — like becoming a billionaire — is an uncertain prospect. Only 3% of redwood seeds ever sprout, and the statistics are similarly dire for entrepreneur startups, where some 90% fail. He concludes it’s risky to be a redwood. That’s the reasons bushes and shrubs are more viable in the world.
As always it’s important to understand what you really want out of the money you’re investing. Money is a means, not an end. More important than building a pile of money is building a plan for that money. And that plan will be as unique as you are. Have you figured out what you value? Do you know how much is enough for you?
I understand the desire to have your money grow as fast as possible, especially considering the market returns of the past few years. I encourage you to step back and take wider view of both your life and the market as a whole to not let overconfidence get in the way of achieving your goals.
I would love to hear from you about risks your willing to take and when it’s not worth it to you. Contact me at the links below.