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Diversification Should Not Be An Excuse For Blindly Owning Bad Investments

Posted by Michael Kitces on Monday, September 12th, 1:08 pm, 2011 in Investments

Diversification is a fundamental principle of investing - examples of the concept date back as far as Talmudic texts estimated to have been written over 3,000 years ago, stating "Let every man divide his money into three parts, and invest a third in land, a third in business and a third let him keep by him in reserve." The diversification principle received a further boost in the recent era when Harry Markowitz's Modern Portfolio Theory supported the notion that the volatility of a portfolio may be less than the volatility of its parts, such that the introduction of even a high-return high-risk asset to the portfolio may improve the portfolio's risk-adjusted return (or even outright reduce its volatility). Yet at the same time, both the rabbis of the Talmud and Markowitz would probably agree that the first step of investing your assets is even more basic: make sure you own stuff that has a reasonable expectation of providing a useful return in the first place. Unfortunately, though, we seem to have lost sight of this rule in recent years!

The inspiration for today's blog post comes from some recent conversations I've been having with a few planners about portfolio construction and how to select investments for a client. In our discussion, the planners were making the case that this past decade has not been a lost one for investors - despite the fact that the S&P 500 is back at price levels it first reached in 1998 and can barely manage to show a positive return, including dividends, since it peaked over 1,500 in March of 2000 - because a well diversified portfolio shows a higher return than the near-0% of the index. This point was further made recently in a New York Times Bucks Blog article by planner Carl Richards, who showed "Why It Shouldn't Have Been A Lost Decade For Investors."

While I'll grant that it's true there are other equity indices that have done better than U.S. large-cap stocks - as the Richards article notes - that's actually the point. There are indices that have done better than the S&P 500. And it shouldn't be surprising. Because the S&P was priced, in advance, to deliver incredibly mediocre returns!

Below is a graph of the Price/Earnings (P/E) ratio of US large-cap stocks, using the Shiller P/E10 data. The long-term average is approximately 16. Notably, though, any time the graph gets materially over a P/E ratio of 20, "bad stuff" happens - from the peak in 1904 that preceded the crash of 1907, to the peak in 1929 that preceded the Great Depression, to the peak in 1966 that preceded 16 years of price stagnation, to the astonishing peak in 2000 - so high, that the scale on the graph has to be increased by 50% just to FIT the peak. Sure enough, once again a tremendous peak in the overpricing of stocks led to a decade (or more?) of stagnation.

On the other hand, this wasn't true of all types of equities. The graph below, from Hussman Funds, shows in blue the relative valuation of large cap P/E ratios to small cap P/E ratios over the past few decades. When the blue line is high, it means large cap P/Es are much higher than small cap P/Es, indicating that large cap is relatively "more overpriced"; conversely, when the blue line is low, large caps are favorably valued relative to small caps. The purple line, on the other hand, is the difference in returns between small cap and large cap over the subsequent 5 years. The results are pretty clear - the lines basically move together. When the blue line is high (large is expensive relative to small), the purple line is high (small outperforms large over the next 5 years); similarly, when the blue line is low (large is cheap relative to small), the purple line is low (small loses to large in performance over the next 5 years).

Hussman Funds Relative Value of Small vs Large and Subsequent Performance

The point here is pretty simple. Advocates of diversification alone have made the case that the past decade was a perfect example of the value of diversification - by owning lots of different equity types, and not just the S&P 500, investors earned better than the near-0% return that the S&P has generated since the peak. The problem is, by looking at any basic measure of valuation, it was evident, in advance, that the S&P was going to have a meager long-term return, and that other asset classes - which had far more favorable valuation - were going to outperform. In other words, the success of diversification over the past decade was not the principle of owning lots of different stuff in your portfolio - it was the success of NOT owning a grossly overvalued investment.

In turn, this means that in reality, diversification only goes so far. Yes, it may have been difficult to know by just how much small caps would outperform large, or at what exact day, week, or month the outperformance would begin. But if you and your clients are truly long-term investors, the data was pretty clear - 2000-2010 was going to be a really bad decade for large-cap investors who bought and held over the time period, regardless of whether it took a few weeks, months, or even a year or few for the differences to manifest.

So the next time you're considering investments for a diversified portfolio, remember: being diversified in an array of good investments that all have the opportunity for favorable return is one thing; owning every investment under the sun, regardless of its investment merits, still fills your portfolio with a bunch of mediocre investments that will likely deliver mediocre returns. Sometimes, the best path is not to "just" own a diversified portfolio; it's to avoid owning bad investments. Don't sacrifice your future at the altar of blind diversification. Every investment should stand on its own merits, too.

So what do you think? Was the past decade an example of the success of diversification, or simply a demonstration that valuation matters? Is it appropriate to follow the long-term impact of valuation, even if there's a possibility of short-term underperformance? Should diversification be the only lens we use to consider an investment, or are factors like valuation relevant too?


  • http://wohlnerfinancial.blogspot.com/ Roger Wohlner

    The point that diversification done for its own sake and or with a bunch of sub-par holdings is a bad idea I'm hoping is pretty intuitive to most advisors. The concept of the Lost Decade has always struck me as something conjured up by the press to sell ad space. I'm pretty comfortable that we can adequately and prudently diversify our client's holdings with quality investment vehicles. Diversification should certainly go well beyond equities and should be focused on the amount of risk that is appropriate for the client in line with achieving their financial goals.

  • http://www.opendoorinvestments.com Joseph Alotta

    Hi Michael,

    Have you ever heard someone fall in love with a bond? Did you ever hear someone, maybe yourself, say "I am so pleased with this bond. I wish I would have bought ten more of these. They have served me so well and I wish all of my portfolio was like this bond?"

    No?? I didn't think so...

    Sincerely,

    Joe.

  • http://www.thompsoncreekwealth.com/ Lance Paddock

    Michael,
    Distill a decade of presentaions, writing and speaking and what I have been saying comes down to exactly what you are saying. Good job. What is surprising is that this idea still meets as much resistance as it does.

    I call my standard presentation "The Real Meaning of Long Term Investing" because as you say, if we are long term investors we should be investing to receive a return, not to merely hold an asset. This can mean changing an allocation, sometimes over very short time frames. I certainly wanted more equity risk in March of 2009 than in March of 2007. A near 60% decline in price changes the risk reward ratio rather markedly. My desire to hold several assets changed in a matter of three months in 2008 such as convertible debt, high yield and a host of other assets and strategies I wouldn't have touched with a ten foot pole in 2007. The reason, the long term return was higher and risk was lower because prices collapsed in the fall.

    In some cases my conclusion as to why advisors resist the idea is not very charitable. I will quote a comment from an advisor I ran across in a discussion of this type of issue:

    "I work for a firm that advocates MPT and long term fixed strategic allocation. I’ve had a hard time convincing myself it’s the way to go. This article confirms that intuitive feeling I’ve had for some time now...
    I think what has made MPT so popular is that it makes my kind of work so &%$@#! easy. Without it most of us wouldn’t have a clue how to allocate between different asset classes, and risk looking stupid in front of clients and colleagues."

    Or, as I discussed with Bob Veres recently:

    "Because the odds of failure are so high many embrace this scientific sounding approach filled with precise numbers that absolve anyone of responsibility (whether implemented via index products or active managers who minimize tracking error) and then surround the decision with pious remarks about how different they are than snake oil salesman promising superior returns."

    To pursue the path I take, and you advocate is to guarantee underperformance at times even if you do a good job. Throw in having to take responsibility for choices made as opposed to just pointing to the market and you have something many of us just do not want to face.

    The consultants tell us it is the way to go. We can spend more time in revenue producing activities if investing is a simple automated process, preferably outsourced. We are told not to market what we can't control (returns.) Certainly there is truth to all that, but we have lost sight of where we can add value in investing.

    Joseph,

    Believe it or not, I have.

  • Tim Hale

    This reminds me of a line from one of Berkshire Hathaway's meeting with shareholders:
    "Which is better: Investing in one company that you know very well, or in 1,000 companies that you know very little about?"

    I appreciate your post, Michael.

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