There's an old cliché about real estate investing that states that the three cardinal rules are: location- location- location. Clever pundits have borrowed upon this refrain and glibly state that the three most important or cardinal rules of investing are: diversify- diversify- diversify. However, careful analysis will reveal that diversification is a multifaceted concept that has different meanings, benefits and even risks depending on how it's used and what its ultimate purpose is. Therefore, my goal is to examine this ubiquitous investing concept from various angles and perspectives.
Diversification Within or Across
When thinking about diversification there are at least two broad categories to contemplate. The first I would call broad diversification or spreading the risk across numerous asset classes. To me, this is analogous to the throw as much mud on the wall as you can while hoping that some will stick idea. Many experts advocate the diversifying broadly approach. However, to my way of thinking, the idea of diversifying just for diversification sake is not always a sound idea. In other words, I would never advocate putting money into an investment that prudent analysis indicated was a bad place to invest just for the sake of so-called diversification.
For example, and I know it is going to generate strong disagreement, I think gold is an asset class at a bubble valuation that should be currently avoided. Personally, I sold mine last summer. The following graph courtesy of Goldprice.org says it all. Gold was an attractive investment in the late 1990's to early 2000's, but it is clearly at extremely high levels now. Therefore, I would suggest taking some (or even all) profits. As I have written before, I feel that fixed income (bonds, etc.) is also at an extreme, and therefore, I temporarily also favor avoiding this asset class. I feel that asset classes should only be used for diversification when they are prudent and sound. To force money into a dangerous investment solely for an artificial commitment to diversification makes no sense to me.
Gold a Twenty year History (Courtesy of Goldprice.org)
Furthermore, I tend to have a much narrower view of asset classes than many of my peers. Regarding liquid assets I see only what I call owner-ship or loaner-ship. Where owner-ship represents equity with the investor positioning themselves as an owner/shareholder, and loaner-ship where the investor loans their money at interest. Others might call this equity versus fixed income or stocks versus bonds. In addition to these liquid assets there would also be hard assets such as real estate, precious metals, commodities and art forms that could be considered as options. But the most important point is that deciding what the most appropriate or optimum percentage of your assets should be allocated to these various asset classes is a subject of much debate.
Diversification-what is the goal?
The most common definition, and therefore use, of diversification is as a risk management technique. This most basic concept of diversification says that you should not put all of your eggs in one basket. On the other hand, assuming that this is wise counsel raises the question: how many baskets is the appropriate number? Should you spread your money over 5 baskets, 10 baskets, 20 baskets, 100 baskets or 1000 baskets? In other words, what is the optimum number of baskets; how many baskets are enough and/or how many are too many?
When dealing with broad diversification, I refer you back to my previous comments regarding equity versus debt. There are many who advocate cute little rules that they promote as the proper way to apply broad diversification. For example, one of the more popular rules of thumb goes something like this: Subtract your age from 100 and put the resulting percentage in stocks; the rest in bonds. In other words, if you're 20 years old, put 80% of your assets in stocks; 20% in bonds. If you are 60 years old, put 40% of your assets in stocks and 60% in bonds, etc. Somehow, these little rules of thumb leave me cold. To my way of thinking, a proper asset allocation plan should be based on the individual's goals, objectives and risk tolerances. When dealing with these kinds of issues, one size rarely fits all.
Next there's the issue of whether your diversification objectives are geared towards reducing risk or maximizing return. An investor with a high tolerance for risk would take a different view of what optimum diversification is versus a person who is very risk averse. An individual with a high tolerance for risk might choose only to invest in equities in lieu of owning any fixed income assets. Who can say that this is a bad decision when it suits the investors' goals and risk tolerances? This then takes us to the questions pertaining to optimum diversification within an asset class.
The most interesting aspect of these important questions is the fact that there is no consensus view. Some experts argue in favor of more diversification while others favor less. For example, Charlie Munger, the famed partner of Warren Buffett, believes that 3 to 5 companies in a stock portfolio is enough diversification. Charlie is alleged to have said that diversification is for idiots. And he is quoted as saying: "wide diversification, which necessarily includes investment in mediocre businesses, onlyguarantees ordinary results. " Alternatively, Warren Buffett seems to agree and has said: "diversification is protection against ignorance."
In contrast, Peter Lynch, the famed manager of the Fidelity Magellan Fund during its glory years held more than 1000 stocks in his portfolio. What is most amazing about this fact is that Peter created one of the strongest long-term track records of any mutual fund that ever existed. Ironically, this is the same man who is credited with coining the phrase "di-worse-i-fication." What many people fail to realize about this is that Peter was referring to an individual company diversifying outside of its core competency through acquisitions. Yet when building his own portfolio, he was happy to own hundreds or even thousands of individual companies.
Then of course there is another aspect of diversifying within an asset class. As it pertains to equities, investors could have a choice of various classes of common stocks.