A common refrain used by investors and advisors to describe diversification is “Don’t put all of your eggs in the same basket.” In its most simplistic terms, diversification means allocating your investment dollars to a variety of different assets, such as stocks, funds, bonds, and deposit products, within different sectors of the economy.
Diversification typically involves investing in companies of different sizes, both large and small alike, in different industries and different sectors, including health care, consumer goods, and services, finance, including banks, energy, transportation, foreign companies, and companies that are judged to be growth-orientated while others are deemed to be value-based.
Furthermore, diversification may be achieved by investing in different asset classes, such as equities, fixed income and commodities, private debt and private equity, and alternative investments, such as real estate and companies that specialize in the environment.
On the other hand, di-worsification is having too many holdings, which can cause dilution and lower overall returns. Typically, fund investors own several funds, each with dozens and dozens of holdings. To make matters worse, many funds have the same holdings despite having different names. This is not to suggest that you only own stocks, funds, or ETFs. What may be beneficial for one investor may not apply to another, however, just keep this in mind when creating your investment portfolio. As Charlie Munger, Warren Buffett’s business partner, said, “The idea of excessive diversification is madness.”
Based on my years of experience, I agree with William Jahnke, who – in his paper “The Asset Allocation Hoax” – concluded, “Investors should be more concerned with the range of likely outcomes over their investment planning horizon, than the volatility of returns.”
There are, in fact, seven reasons why investors should determine portfolio diversification this way:
1. Many investors are railroaded into portfolios that are cookie cutters, often lacking the personalization where investments are selected to meet specific needs for different planning horizons. All too often I see a one-trick pony approach to diversification, where some advisors exclusively recommend mutual funds, while others believe that ETFs are preferable, while others promote individual stock ownership. Often, this is because the advisor in question may only be securities licenced and as such is often limited in the investment solutions they can provide.
2. Today we are seeing historically low rates of interest on perceived low-risk loaner types of deposit products – such as treasuries, bonds, savings accounts, and CDs. The impact of this cannot be understated, as it will be challenging for investors to make positive real rates of return after taxation and inflation for some time to come.
3. People are beginning their careers later than many generations in the past, which means they are beginning to invest at a later time in their lives. The accumulation phase is shortening but we are living longer and retiring sooner, so something has to give. A 1995 landmark study, conducted by Dr. Neal Cutler and Dr. Davis Gregg of the Boettner Institute, introduced the concept of the human lifespan as it applies to financial matters.The study concluded, “Human lifespan consists of the accumulation stage and a spending stage. Over the past number of years, there has been a radical change in both of these phases. The accumulation stage has shrunk, because people are entering the workforce at a later stage and retiring earlier while the spending stage has increased due to our lengthening lifespans.” In other words, the combination of commencing to invest later in one’s life, and living longer, but retiring earlier, is going unnoticed by many, and poses significant risks to one’s financial future.
4. Defined benefit pension plans, which guarantee a predictable lifetime pension, are now being replaced by defined contribution plans, which place all of the risk in the hands of the investors, as there are no retirement income guarantees. Furthermore, many existing defined benefit pension plans are below the amount needed to fund long-term pensioners’ retirements and may require increased contributions to remain viable
Therefore, historically, people retiring on a guaranteed benefit pension will, in the future, represent a smaller percentage of retirees. This will require a shift in how people invest and are just one more reason why investors have to ensure that their portfolio asset allocation maximizes returns, reduces current and future income taxes, targets inflation, and is designed to make money in both up and down markets, all of which works in synergy to maximize compounding.
In addition, investors with employee-defined contribution plans have to make sure that the investment selections they make in their plans are diversified, taking into consideration any personal investment plans.
5. We are an ageing society, which means more people are retiring than ever before, and this may have the unintended consequences of unwanted taxation and negative rates of return in the event too many people begin redeeming their funds at once. Money managers may have no choice but to sell assets, so investors have to understand that investments pooled together with thousands if not millions of other investors may be affected, even if they do not withdraw any funds for themselves.
6. Because of the ageing society, employment demographics are changing. Currently, there are about four workers for every retiree, down from just over six workers fifty years ago. Forecasts show that within twenty years, the workforce will consist of just over two people for every retiree. This may provide additional challenges for the governments of the day as they wrestle with having to service a rising national debt, with potentially less income tax revenue. This means that income taxes will have to be increased, potentially affecting retirees’ cash flow and a need to increase the age of retirement, which will mean fewer healthy years in retirement.
7. Investors have to guard against having a portfolio that is overconcentrated or has too many holdings within the same industry or sector. One tool that is used by the industry to create “efficient portfolio selection” was developed by Harry Markowitz, an American economist, and dubbed “mean-variance.” Contrary to the notion that this creates efficient diversification, it often leads to highly concentrated portfolios.
As you consider your own diversification strategy, remember that Warren Buffett’s Berkshire Hathaway portfolio10 consisted of about fifty publicly traded stocks as of September 30, 2020 (CNBC markets); Bill and Melinda Gates’ portfolio11 consisted of seventeen as of March 31, 2021, totaling over 20 billion dollars.