Diversification or Diworsification?

Diworsification
“Diversification is the only free lunch in investing” 

This is a common refrain in the world of financial advisors (we at Richucation of course don’t think much of what financial advisors (more accurately financial salesmen) have to say since they generally don’t know much if anything about good investing and beating the market).


What do they mean?

They follow the statement up with “it’s the only way to decrease your investing risk without decreasing your expected return”.

In other words, let’s start by recognizing the theory of diversification isn’t to boost your pure returns but rather to boost your risk adjust returns.

It’s worth noting what they define as risk probably isn’t what you or I define as risk.

Are they right?

Let’s start by defining diversification.

In simple terms diversification means splitting your investment up between multiple investments rather than just one.

There are whole ranges of diversification strategies for good reason as we’ll soon see.

It might include buying multiple investment properties rather than just one.

It might involve buying multiple stocks instead of just one.

It might involve buying multiple asset classes instead of just one.

There’s a literal gradient of just how diversified your portfolio actually is since you could apply one or all of these and you could diversify between one or hundreds of potential assets and strategies.

The theory is predicated on two assumptions:

  1. The risk (either measured by the odds of losing money or the volatility) is lower when you diversify
  2. Your expected return remains the same

The first of these is perhaps the easiest to argue. After all, if you’ve got one company what’s the odds it goes bankrupt? On the flip side what’s the odds two companies go bankrupt? It’s like the odds of flipping heads on two coins rather than just on one.

Likewise, in theory the more diversified your portfolio is the more the ups and downs of individual assets will level each other off smoothing out the volatility.

Makes sense right? Indisputable? Not so much as we’ll see in a minute.

What about the second assumption?

The second assumption presumes the future expected returns of all investments you’re diversifying between is the same and this probably isn’t true.

Consider for example using CAPE by country as a measure of the future expected returns of given stock markets over say 10 years. Diversifying between them would in theory lower your volatility and decrease the chances of any one country going down dramatically but the future expected returns between these assuming a return to the mean over time isn’t even remotely similar.

But wait there’s something else…


A Return Booster They Aren’t Telling You About

There is actually an increase to returns outside of decreased risk most people are unaware of but does something to validate the idea that diversification might be a free lunch after all.

Assume you had average annual returns in a portfolio over 6 years adding up to 60% of 10% per year.

Assume this could come in two forms:

  1. 10% per year for 6 years
  2. 20% per year every second year and 0% per year every other year for 6 years (the order of years doesn’t matter the math works out the same)

The first case represents no volatility and the second case represents much higher volatility.

On a compounded basis what does this do to our returns. You’d expect the returns to be identical right?

After all, whether you earn 10%/yr for 6 years or 20%, then 0%, then 20%, then 0%, then 20%, then 0% the average is still 10%/yr and the total simple returns are 60% so you end up the same right?

Wrong, let’s look at the math:

1.1 * 1.1 * 1.1 * 1.1 * 1.1 * 1.1 = 1.77 or 77% actual return after compounding

Vs

1.2 * 1 * 1.2 * 1 * 1.2 * 1 = 1.73 or 73% actual return after compounding!

Say what?

How can one yield 4% more over 6 years when the average returns are the same?

You take some time and redo the math for yourself changing the order and playing around with alternatives if you like. I did when someone first showed me this and I couldn’t believe it.

What this shows is without rebalancing, without any fancy strategies, on the exact same average returns over time lower volatility boosts ACTUAL returns and higher volatility hurts ACTUAL returns.

This is one of the biggest fallacies in the financial sales and investing community. They’ll tell you average returns as opposed to actual returns.

Why is this a bunch of nonsense?

Let’s take a look at a more extreme but real example.

Say you had an investment where one year you lost 50% and another year you made 50% your average return is 0%. Let’s compare this to a portfolio that did nothing it had an actual return of 0% how do they compare?

Assuming $100k invested if you lose 50% in year 1 you’re down to $50k now you grow this by 50% and you’re up to $75k…your actual return is -25% but your average return is 0%.

Once again it doesn’t matter what order these years come in and the effect gets magnified the more you increase the volatility, which you can see clearly if you assume one year (doesn’t matter which year in a series) you have a 100% loss. You could have had 1000% gain five years in a row and it still wipes you out and your actual return drops to a -100% even though your average could be thousands of percent.

So in this sense simply decreasing your volatility is actually a free lunch.

This is one of several reasons we recommend the small initial part of a person’s portfolio go into close to zero volatility investments when building wealth until you leave to invest well.


The Counter Argument to Diversification

Lowering volatility mathematically increases returns assuming returns average out the same but herein lies the big gap.

Returns generally aren’t the same between assets or asset classes.

Proponents of diversification argue it’s extremely hard to successfully choose assets or timing that will outperform the market but this is a question of investing method not the underlying theory or math.

Diversification is a protection against ignorance.

– ​Warren Buffett

I’d expand this to suggest diversification is a protection against rare unexpected events especially Black Swans much like insurance.

For example, say I purchase two properties. There’s always a risk of a fire or a bad tenant, etc. Although we can improve our odds of these things not happening they are mostly outside our control and this is a great example of where diversification up to a point can help you.

The problem with diversification is you can’t take advantage of big winners either.

For example, say you split your portfolio between 10 different assets and one of them does incredibly well posting a 1000% return.

Instead of this giving you a 1000% return across your portfolio it will only give you a 100% return across your portfolio because you’ve only allocated 10% of your capital there.

In this case diversification didn’t help you it hurt you. Diversification was actually diworsification.

Concentration is required to beat the market and achieve optimal returns

Logically if you could completely diversify across the entire market your returns would equal exactly the market returns minus fees so it would be impossible to beat the market.

Matching the market is better than not investing and an ok place to start when you don’t know anything and are focused on building income but eventually you need to move away from this strategy if you’re going to do truly well.


The Second Fallacy of Diversification

Additionally, we should revisit that assumption that diversification decreases risk (either odds of losing money or volatility).

If you’re simply picking assets blindly this is true meaning on average with no skill it will achieve this result but saying so completely misrepresents the drivers behind risk and reward.

While it’s common to cite average returns, average volatility, etc. the truth is hundreds of assets every year outperform the average and hundreds have lower than the average risk or volatility, it’s the nature of averages that they include both the highs and the lows.

Your objective as an investor is to minimize risk while simultaneously maximizing returns, so called asymmetric risk reward.

If you understand how to do this you can actually decrease your risk by concentrating. This is essentially what Warren Buffett has done both radically outperforming the market over 40+ years and experiencing fewer losses than the market in general.

Diversification once again is diworsification if you know how to pick the assets and/or the timing well.


So, is Diversification a Free Lunch or Diworsification?

It depends.

One point is fair, diversification is a way to lower volatility and risk virtually without any knowledge so in this sense it is free.

So, compared to completely random concentrated bets yes it is a free lunch.

But compared to someone who knows what they are doing diversification isn’t only not a free lunch it’s diworsification and you’re better off to concentrate your holdings intelligently, it’s the only way to beat the market.

If you’d like to learn more about investing well, beating the market, etc. check out some of our other articles, take our trainings and reach out to us to collaborate, for investment ideas, deal flow, and consulting.

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