Too Much Innovation Can Get You in Trouble
Don’t Get Too Creative with Diversification in 2021
by Bryan Ellis
There is a word you should probably get ready to hear a lot in 2021. No, it is not “unprecedented”. That was last year’s word. This year’s word is going to be different. It is already incredibly popular. In fact, some of the world’s best-loved “experts” in investing use this word all the time already. It is a word you will probably find quite familiar: Diversification.
It is hard to imagine we might even need to describe the concept of diversification since it has been aggressively shoved down our throats by Wall Street for decades. In fact, we have heard it so many times, many investors accept the need for “portfolio diversification” as gospel truth without analysis or dissent. No matter how good a concept or idea may be, blind acceptance is a problem. In the case of the diversification myth, blind acceptance can be absolutely catastrophic to your long-term returns.
So, the concept of diversification is simple: “Don’t put all your eggs in one basket”. This is also something we have all heard time and again, but do not let that tempt you away from analyzing this concept further. There is a grain of truth to the idea that you should not “put all your eggs in one basket” or rely on a single investment to make or break your future financial situation. It is also true, as many proponents of diversification point out, that investors should “change the allocation of capital to match life circumstances”. Absolutely, you need to adjust your investments so that you have an increasing amount of liquidity as you edge closer and closer to retirement. However, this is where the truth of the myth ends, and the “myth” part of the equation begins.
Diversification Is Not an Investment Strategy
The concept of diversification is usually used to advocate owning a variety of stocks, bonds, and mutual funds. This is, in reality, hardly diversification at all. This “variety” is really just owning different types of the same asset class. This is not diversification.
Here is the important thing to remember: Diversification is a hedging strategy, and hedging is designed to prevent loss, not produce gains. This, in and of itself, is not a bad thing. After all, every self-directed investor, retirement investor, and real estate investor out there wants to first protect their existing capital and then grow it. But diversification (hedging) is not the best route to this goal.
Let’s take this analysis a little farther. Ask yourself: Is diversification so popular because it is the best investment strategy? The answer is simple: No. Not at all. Diversification is so popular because it is the most legally prudent strategy for Wall Street and for conventional financial professionals. After all, hedging prevents loss, and loss prevention provides shelter from financial culpability in the event that things in your portfolio go south. If you invest in one stock only and that stock takes a dive, it is easy to blame the individual who advised you to buy that stock. On the other hand, if you own 100 stocks and most or all of them tank, it is easy to argue that was a macro-economic event beyond anyone’s responsibility or control.
The biggest problem with diversification as an investment strategy is that it guarantees mediocrity. Will your lower-end results be mediocre? Probably so. That may be acceptable when everyone else is experiencing massive financial distress. Will your upper-end results be mediocre? Probably so. You must ask yourself if you are willing to accept that cap on your returns and potential.
Don’t Just Take It From Me
Interestingly enough, not everybody accepts diversification as an unassailable strategy. I do not. And, in fact, the most successful investor of all time, Warren Buffett, does not either. He famously observed, “Diversification is protection against ignorance. It makes little sense if you know what you’re doing.”
Buffett has really lived by that strategy, too. He has tended away from buying pieces of companies, preferring to buy entire companies. Diversification is not a hallmark of Berkshire Hathaway.
The question you must ask yourself is, “Do you know what you are doing?” If you do, then you must seriously consider taking the time to truly respect your capital, seek out truly excellent value propositions, and identify potential for real value. If you have the knowledge and ability to do this with your investment capital, then your portfolio deserves nothing less. This year will be full of opportunities for real estate investors with knowledge, expertise, and experience. Leverage your experience toward making this year wildly productive instead of merely mediocre.
