Accounting for the Costs of Investment Diversification
Diversification is a popular tool at any time, but as investors seek to protect themselves even more now due to the uncertainty of the stock market, they need to also weigh the costs.
With economic projections stabilizing more, and remaining quite favorable for the foreseeable future, some people are still going to worry about these things, in addition to any number of other concerns that may have them wanting to hedge their stock market exposure more.
There are some actual issues to be aware of as well, such as how the trade war with China will play out, as well as how a Democratic winning the presidency next year may affect things. The fact that this bull market has gone on for so long isn’t one of the meaningful fears, but even ones without merit can cause us to act as surely as the ones with merit can, because fear does not discriminate very well.
We might think it prudent to seek out even more diversification than we normally do, but what we do not want to do is just hedge more and believe that hedging is good in itself, and even one that is immune from questioning. This is how we approach diversification generally anyway, but this comes with a real price and requires justification by way of a cost benefit analysis of some sort.
If we aren’t thinking about these things at all and just take for granted that our hedging strategies are good ones, then all will seem well, and we may be hedged well in excess in reality but still want to do more.
We may think that we have a good idea of the costs and benefits of diversification, but this does not excuse us from trying to get a better handle on understanding this and at least ensure that our strategies are at least sensible. If they are not, then acting on beliefs that are not sensible surely cannot be a good thing.
We need to start by thinking about what benefits diversification brings, and especially what we need to give up to get these benefits, to come up with an idea as to what amount of diversification is preferable and justified and what amount or method of achieving it is excessive and therefore costly overall.
Diversification only seeks to achieve one thing, to reduce risk. We aren’t out to eliminate all risk though, because we wouldn’t be investing at all if this was the goal, as what we want to confine ourselves to is to seek to get rid of excessive risk.
With any given strategy, there are two elements that matter, which is the amount of money that we may expect to gain with it and the amount that we may lose with it. Both of these calculations pertain to the point of action, where we exit the trade, whether that be after a certain amount of time passes or based upon performance factors.
If we aren’t going to sell it at a certain point, then whatever risk that it may be under shorter-term should not ever matter to us, and we especially do not want to be paying a big price for no real benefit.
The starting place for our calculation needs to be what we would be doing purely based upon return, where we then determine what the risks are and then decide if this has to be dialed back. We may then choose to place some of our money in a less risky asset to reduce the risk, or we may simply monitor our positions and choose to instead use market timing to manage the risk, but we do need to be doing something if the baseline risk is unacceptably high.
If We Aim to Achieve Mediocrity, That’s the Best We Will Ever Do
The first mistake that people make when doing this is to instead set the baseline at the level of the overall market, calculate the risk and return ratio of that, and then reduce risk from there to the extent that they feel that they need to.
Since the goal here should clearly be to achieve the best reward to risk ratio, excluding strategies that present a higher to much higher potential for return and may even turn out to be less risky overall than the market, and we don’t want to exclude these things out of hand like we like to do.
For those who have a long time horizon, and plan on holding through all the ups and downs that stocks go through over the years, while they may not want to put all their eggs in one basket by investing in a single stock, the upward nature of stocks will in itself reduce the risk enough to allow us to focus on the good stuff much more than we do, those stocks with the highest potential for return.
We may not want to spread things around by even going with a fund that tracks a major index, even though that’s what people almost always do. They may sprinkle their portfolios with growth funds to add some spice but there may not be any good reason here to want to water these spicy stocks down at all.
It may appear to us that, since indexes go down less than more powerful stocks, the indexes would therefore represent a safer investment, and point to this greater drawdown risk as evidence of the problem.
Approaching risk management by looking at drawdown risk is not something that makes sense for an investor to do, and this is because we generally will hold the investments through these periods. If we are comparing two investments and one goes up twice as fast as another but also goes down twice as fast, and they mostly go up, and we will reach higher heights with an even greater degree of confidence, as is often the case, we end up giving up far too much here and the diversification ends up costing us a lot of money.
If we were getting our money’s worth in risk management, where a drawdown of 20% would be acceptable but a larger one that a growth fund might suffer would not be, there are still better ways to look to manage this risk than just watering things down a lot. We could, for instance, just set a limit on the risk we’re taking with our higher potential stocks and get out once we reach that point, and only re-enter when it is safe to do so.
Provided that our growth approach outperforms the market by enough though, as a top growth fund will, the extra growth that we have banked will tend to have us well ahead even at the worst of times, as long as we’re in a bull market that is. If we aren’t in a bull market, this is not the time to want to be in stocks anyway, but even when they come, growth strategies still deliver more overall in the long run.
If you have gained 100% return from a growth fund and the market has only gone up by 50% over this time, even if you get a pullback of an extra 20%, which is as bad as it ever gets really, you are still up by 30% in this example. If we go with the index fund instead, the benefits are considerably outweighed by the costs of this diversification, so excessive diversification significantly reduces performance overall.
This involves taking into account not just risk, but the combination of risk and return, where we actually look to determine what opportunity costs the hedge has and look to optimize both instead of mindlessly looking to cut risk.
As sensible as this approach is, it is a long way from strategies that individual investors use, which anyone at all familiar with investing will readily attest to. The curriculum that investors are taught is on the other end of the spectrum, the side that completely ignores the cost of hedging and ends up promoting strategies that cost investors a huge amount of money over the years.
Going all in with an index fund is even seen as too daring in a lot of cases, where we’re told to water down this watered-down bucket of stocks with other assets, especially with bonds. This just makes things worse as it takes the watered-down returns of an index funds and replaces a percentage of it with investments that much more paltry returns, lowering our risk-to-reward ratio and our expected returns quite significantly.
This has gotten so bad that overdiversification could even be described as a disease that afflicts almost all investors, and the fact that so many people fail to reach their financial goals is due in large part to their having the need to water down their portfolios so much, in a way that simply is not warranted.
We invest in stocks because we expect them to deliver a positive return over time. We can actually compare two different approaches, with and without their cherished overdiversification, and the undiversified one will tend to be well ahead of the diversified one at any point in time. It’s only at the end that matters but if shooting for bigger gains will have us ahead every step of the way, choosing the position that is always behind involves no benefits at all and just losses.
We Should Not Use Diversification as a Weapon Against Ourselves
To get past this huge mistake, we need to understand risk more dynamically, where we’re just not looking at how much it can give back but what the net is when we add in the extra gains that we get. Although the need for this should be obvious, it is far from that with the masses, who simply follow mistaken advice without question. There is no bigger mistake than overdiversification and nothing even comes close in fact.
This ends up being a far more significant mistake than just holding on to everything and exposing ourselves to the maximum amount of market risk, even though a skilled investor can significantly beat the market this way by selective timing of their positions. If we are able to do this as well, at least to the point where we can avoid a good portion of bear moves, we can certainly help ourselves, but missing out on this pales in comparison to what we lose to overdiversification looking to invest in the market instead, and especially with seeking out stocks that underperform the market, or worst of all, any amount of bonds.
The real problem with this style of hedging is that it hedges mindlessly and does so at times where we should never wish to dilute things. Any hedging that has been done this way over the last 10 years has been mercilessly punished even though people are none the wiser.
They may think that their 300% return over the last 10 years is mighty nice, and they don’t even realize that a better strategy may have produced gains several times larger. If they take the time to look back at what has happened over this time, even if we include both major sell-offs over the last 20 years with a good growth fund, they would be in for a big surprise.
People do look back at hot stocks and wish that they knew then what they know now, but people did know this back then and took advantage of this sort of stock, the ones that weren’t spooked by the lack of diversification that this would have required.
It is very important that we select our funds with care, and we’re after those who get the fact that they need to be in stocks with the most potential for growth but are otherwise stable enough to not present too much risk. We don’t ever want to be messing around with stocks that are losing money right now even though a lot of promise might be priced in, and this is the biggest mistake people made in the years leading up to the bursting of the so-called tech bubble in 2000.
We also don’t want to just ignore risk, as if we do get another crash like 2000 or 2008, we might want to play a little defense here by not being willing to stick around for the full brunt of the crash. There is a time and a place for diversification and it is when the risk of going down exceeds the probability of going up, and this is where hedging becomes wise, where you’re taking money off the table that is likely to decline in value rather than doing this when it is more likely to appreciate in value, which is never wise.
The biggest mistake by far though is to be selecting mostly inferior investments in our portfolio because we are either too afraid or too misinformed to take our role as investors seriously enough to seek out a better balance of risk and return than gets dished out to them by the common view, and walk away with heaping plates of delicious food rather than one that is mostly weeds.
If it turns out that even if we ignore risk altogether and just go with top performing stocks in a top performing sector such as technology, we actually can manage risk better this way than the diversification fanatics do. At the very least., we want to be hedging real monsters and not just ones we imagine are hiding under our beads and may attack us anytime without warning.
This is not about being good at timing your investments, which is actually a bonus, and although doing this on an ongoing basis does take some real skill, it takes very little indeed to pull back when things clearly warrant it, such as what happened in the aftermath of both these recent crashes. Neither really crashed, it was more like a slow ride down into the depths where gloom and doom ruled the day and we had to ignore it to want to hang around during these times.
If we are up for it, we can even put together our own portfolio of stocks, adding the most promising ones and deleting them when their promise sizzles too much and replace them with ones doing better.
This is actually the ultimate approach to seeking growth as we can achieve much more optimal performance than any fund ever could due to our being able to enter and exit positions instantly, which is a huge advantage over how funds need to do this.
It is not hard at all to find good stocks to want to be in, as all you need to do is look at how have been doing to decide, and we then will keep them as they continue to do well and toss them if they fail to perform well enough. Not performing well enough doesn’t mean going down in price, as just not going up enough to keep up with our other stocks where there is a better candidate out there that can replace it is enough.
This is what the optimal strategy looks like but this is well beyond the interest and perhaps even aptitude of most investors though, and people pick funds not by accident but because they feel that this is the only alternative. We need to be careful in picking funds, and especially want to not only look at their performance but what kind of stocks they hold.
This is not unlike looking to hire people to work for you, where you’re looking to hire the best candidate or candidates, and you wouldn’t just hire people randomly and expect to do anywhere near as well. Stock and fund picking work the same way, and we should be out to help ourselves the most and not just settle for mediocre because so many others do and this has become so acceptable.
As far as diversification goes, we need to understand its merits such that we will choose as little as needed, and no more, and never look to dilute our returns without any benefit like people do by hedging in bull markets.
There is no better way to help ourselves achieve our financial goals then looking to do a better job of what investing is supposed to be about, which is making wise choices to seek out the best possible returns while keeping risk sufficiently under control. This never includes the mindless diversification that so many of us insist on even though we do not really understand why this is needed other than people telling us we should.
No matter how many are lined up on the wrong side, we need to avoid the temptation of joining them and at least think about what we are doing a little more instead of assuming this is all way too complicated for us to understand. We’ll never understand anything without trying though.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
Contact Ken: ken@marketreview.com
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