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Why Diversification is a Bad Idea

Nov 2, 2016


We've all heard the saying, 'Don't put all your eggs in one basket.'

It's one for the ages. Timeless advice.

Benjamin Graham is recognised as the father of value investing; he was also Warren Buffett's mentor.

In his 1949 book, The Intelligent Investor, Graham advocates spreading your investment eggs into multiple baskets as the foundation for conservative investment.

Warren Buffett needs no introduction. His investing prowess is legendary.

Based on a deeper understanding of investment markets, Buffett has a narrower view on diversification. The above quote from Buffett appears in Robert G Hagstrom's 1997 book, The Warren Buffett Way: Investment Strategies of the World's Greatest Investor.

And then there's Jim Rogers' view - concentrate your assets in one carefully chosen and watched basket.

This was the advice in his 2009 book, A Gift to My Children: A Father's Lessons for Life and Investing.

There's no doubt the considered wisdom is still to diversify your portfolio - across cash, shares (Australian and international), property and precious metals.

Even my own model portfolio is based on spreading funds among five different asset sectors.

However, my current portfolio is highly concentrated - 100% cash and term deposits...or as close to this allocation as you can get.

The considered wisdom is that a portfolio weighted heavily in cash - while providing security of capital - is at risk of having its buying power eroded by inflation.

Considered wisdom regards my overweight cash position as ill-considered nonsense.

The reason I pinpointed the years when each of the above quotes was made (1949, 1997 and 2009) is to demonstrate how thinking has changed over the years.

In 1949, the greatest credit bubble in history was in its infancy. The markets functioned largely on their own from artificial stimulants. Markets rose and fell on the merits of the earnings produced, and the multiples applied to those earnings. Central bankers were neither seen nor heard.

It was also around this time - in 1952 - that Nobel Prize-winning economist Harry Markowitz introduced the modern portfolio theory (MPT).

According to Investopedia:

  • '...MPT suggests that it is possible to construct an "efficient frontier" of optimal portfolios, offering the maximum possible expected return for a given level of risk. It suggests that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification, particularly a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket.'

Put simply, Markowitz argued that, by holding combinations of different shares and asset classes (ones not positively correlated), portfolio risk can be reduced.

Life was simpler back then. Behavioural patterns were a little more predictable. Options trading was a mere fraction of what it is today. Markets in 1950 were free from central bank manipulation, and were not subject to the complex web of interconnectivity, dark pools and algorithmic trading we have today.

Calculating risk and reward parameters - from various asset classes and sectors within those asset classes - was a tad more reliable. The risk-free barometer - the US government bond rate - wasn't being suppressed, tampered with, or beaten down by central bankers. The market determined the rate based on prevailing credit conditions and the inflation rate.

To demonstrate the ebb and flow of markets, the Shiller P/E 10 ratio in 1950 was 10-fold (undervalued). Over the next 16 years, the P/E expanded to around 25-fold (overvalued). In 1966, the market began a prolonged period of correction...with the P/E 10 finally resting around the sevenfold mark in 1982.

Day Chart

Markets breathed naturally...inhaling and exhaling.

They functioned in the manner we think capitalist markets should - standing or falling on their merits.

While share prices stagnated in the 1970s, property values rose, gold soared, and interest rates ballooned to 18%.

Diversification across the four asset classes would have produced a positive outcome during what was a fairly tumultuous decade.

But after the 1987 crash, the newly appointed Fed chairman - Alan Greenspan - changed the rules of the game.

Central banks started to intervene (ever so slowly at first) in the functioning of markets.

After a decade of Greenspan's tinkering, Buffett would have realised a narrower concentration of investments would deliver far better results than the traditional scattergun approach. He understood the traditional drivers were a changin'.

Since 1987, central bankers have done all they can to stop the markets from exhaling.

This has led to a point where we are holding our collective breath...wondering how this experiment in asset price manipulation is going to end.

The following chart - which shows the explosion in major central bank balance sheets - comes from none other than the Reserve Bank of Australia.

Since 2008, the three central bank amigos (listed below) have created US$8 trillion out of thin air.

10-Year Government Bond Yields

Here's another chart from the RBA:

Major Central Bank Balance Sheets

The risk-free bond rate, against which all other assets are priced, is being deliberately suppressed for the triple benefit of asset price elevation, cheaper credit, and lower debt servicing costs.

In contrast to the heavy hand of intervention we have today, in the pre-Greenspan era, bond rates were priced by the market. There was no Bank of Japan announcement pledging to do all in its power to keep 10-year rates at zero.

The diversification espoused by Benjamin Graham and Harry Markowitz was for an era when markets sent back reasonably reliable signals of risk versus reward.

Not so these days. All the market wants now is confirmation the Fed has its back. Fundamentals count for diddly.

That US$8 trillion printed into existence since 2008 had to go somewhere.

Any guesses? Try these on for size.

Bonds. High-yield securities. Shares. Property. Collectibles. Infrastructure. Private Equity. Venture capital.

I presume the Fed's outright determination to create 'the wealth effect' is why, in 2009, Jim Rogers said you should put your eggs in one basket and watch it very carefully.

Running in tandem with the asset price inflation (created by the rising tide of cheap and abundant money) is a derivatives market measured in the hundreds of trillions of dollars. No one knows exactly how big this weapon of mass destruction is...and that's frightening.

These days, a diversified fund might look something like this...a wagon wheel of supposedly uncorrelated assets.

What you Think you are investing in

In fact, what you are actually buying into is this:

What you actually you investing in

Diversification amounts to nought if the capital behind those asset classes can be traced back to a single denominator...quantitative easing (Q/E), zero interest rates, and the chase for yield.

Central banks have floated all boats higher...with one exception. You guessed it - cash.

Since 1950, debt accumulation - for consumption and asset acquisitions - has been on the up and up.

The US debt escalation typifies the Western world's increasing dependency on debt to make economies and investment markets function.

What you actually you investing in

The world we live in today is vastly different to the 1950s. Benjamin Graham and Harry Markowitz would not recognise it. The prudent bankers of their era are long gone. Today's bankers are reckless.

The risks embedded in the system are so deep and so great that no one can reliably identify them. In recent history, we've witnessed the near-death experiences caused by subprime lending and the collapse of hedge fund management firm Long-Term Capital Management (LTCM).

In the context of global market capitalisation, the dollar amounts involved in both these cases were not overly large...which goes to show just how fragile the system has become.

How do you accurately gauge the trade-off between risk and reward when what were once considered 'risk-free returns' - US government bonds - are now openly referred to as 'return-free risks'?

It's impossible.

In my opinion, diversifying in these conditions is the equivalent of spreading your belongings around different cabins on the Titanic.

What started with a degree of naivety and innocence in the 1950s is destined to end with grand deception.

It's ironic that what has long been considered a risk-minimisation strategy now exposes investors to maximum risk.

Please note: This article was first published in The Daily Reckoning Australia on October 31, 2016.

Vern Gowdie is a contributing editor to Money Morning - Australia's biggest circulation daily financial email. Vern has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia's Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top 5 financial planning firms in Australia. Vern has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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