Does it pay to diversify?

The future is always coming up with surprises for us, and the best way to insulate yourself from these surprises is to diversify. - Robert J. Shiller

By AARON KATSMAN
Illustrative photo of Israeli money (photo credit: MARC ISRAEL SELLEM)
Illustrative photo of Israeli money
(photo credit: MARC ISRAEL SELLEM)
Tech stocks are the rage on Wall Street. Over the last few months many companies have seen their stock prices double and triple. I know that I am going to sound like an old fogey, but it seems that the fact they have little in the way of profits doesn’t seem to be important. It’s all about higher revenues.
Sound vaguely familiar? I am an eternal optimist when it comes to investing, but I also have a long memory. Many of the same market trends we saw in the run up to the tech bubble bursting in 2000, seem to be repeating themselves. I am well aware we are in the midst of a technological revolution, and the world is a much different place than 20 years ago. It’s just that when IPOs double on their first day of trading, profits are no longer important, smaller companies see their stock prices move up 10-20% every day and clients become impatient because they bought a stock three weeks ago and it hasn’t moved more than 2%, that I start getting nervous and remember what happened two decades ago.
Don’t get me wrong, I love technology and in my column told investors to look at the sector back in March when the market was crashing. I’m just getting nervous. When it comes to investing money, there is an inherent conflict or tension about how to do it. While some people believe in diversifying their investments, there are those who do just the opposite. In this case, they invest large amounts of money in a few, concentrated investments in our case technology. The question is: Which is the better approach?
Concentration
What is actually happening today is that broad market indices are becoming very concentrated. Christopher Hogbin, head of equities at AllianceBernstein writes, “The wide dispersion of returns in different parts of the market is creating new distortions. The extreme case is the Russell 1000 Growth Index, where five stocks (Microsoft, Alphabet, Amazon, Apple and Facebook) now account for a record 36.9% of the entire benchmark. In broad global benchmarks these same names have a larger combined weight than any entire country’s market, other than the US.” Hogbin continues, “Why is this a problem? In the past, extreme levels of concentration in a small group of stocks has typically reversed. If some of today’s mega-caps underperform, investors who own a benchmark or a heavy concentration in these names could be exposed.”
His basic premise is that US markets are getting expensive versus the rest of the world. I would add that within the US certain sectors are expensive in relation to others. As such investors should review their portfolios to see if they are over concentrated in one sector or market.
Diversification
According to diversification theory, a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any single individual investment. Diversification tries to smooth out volatility in a portfolio caused by market, interest rate, currency and geopolitical risks. In layman’s terms, don’t put all your eggs in one basket.
One and done
As I have written many times, if Bill Gates had diversified, he would not be where he is today. If Gates had sold off his Microsoft stock 30 years ago and created a diversified portfolio, he wouldn’t be one of the richest men in the world. He’d be rich, just not that rich!
Back during the internet bubble, I had a client who wanted to become a multi-millionaire and retire by putting all his money into Nokia stock. He got close, and then the bubble burst and so did his one-stock portfolio. Last I heard he is still working 9-5.
What’s the answer?
For most investors it would seem that a diversified portfolio makes sense. The fact is that most investors have neither the time nor know-how to successfully get rich by investing in a few stocks. By investing in a diversified portfolio you can both lower your risk and enhance your returns. Sounds like a good deal. Building wealth takes time. In today’s culture of instant gratification, we look to get rich quick by investing all our money in “hot stocks.” Unfortunately for most, the opposite occurs.
For the general investing population the way to build wealth over time is to continue to save and keep investing in a diversified manner. For those trying to hit it big in a very short period of time, my gut feeling is that it won’t end well.
The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc. or its affiliates.
The writer is the author of Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing. www.gpsinvestor.com; aaron@lighthousecapital.co.il.