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“Are my Eggs in one basket, or is that concept already cracked?”


In the financial services industry we constantly hear different jargon and phrases, and one phrase often quoted as it relates to an individual’s finances is: “don’t put all your eggs in one basket”. The saying has been around for centuries, and can be traced back to printed text in the 1660’s[1]. The phrase essentially states that concentrating all of your prospects or resources in one thing or place can be detrimental because the risk of losing everything increases drastically. Simply put, diversification of prospects or resources can help eliminate concentration risk. We recognize a lack of diversification in one’s investment holdings can cause the individual to take on undue risk. The issue we want to address is the misuse of the term “diversification”.

Let’s begin by discussing what diversification is, and what it isn’t. Diversification can be applied specifically towards different companies that comprise a portfolio, different investment frameworks, different managers’ thoughts and application of philosophies or strategies, different industries or sectors, different types of assets, or perhaps different types of a company’s revenue streams. For the purpose of this blog we will focus on diversification of one’s investment holdings and managers. In the past decade, particularly, we have seen the rise of index investing. Index vehicles (i.e. index mutual funds or ETF’s) are typically a basket of securities mimicking a certain benchmark such as the Vanguard 500 Index (VFINX), which holds 508 securities[2] and mirrors the S&P 500; or the Vanguard Total Stock Index (VTI), which holds 3,592 companies[3] and simulates the CRSP US Total Market Index. Some index-tracking vehicles such as the SPDR® Dow Jones® Industrial Average ETF (DIA), tracks the Dow Jones Industrial Average Index (Dow), and holds 30 companies[4] (it drives us nuts at LBW when the media is so focused on the Dow as an economic indicator – it’s only 30 companies! For more information, read our blog titled “What’s Beneath the Covers: The S&P 500 and Dow Jones Industrial Average”). When it comes to diversification of investment holdings, what is too much and what is too little? To help answer that question we lean on Peter Lynch’s (manager of the Fidelity Magellan Fund from ’77 – ‘90) coined word: “Diworsification”. “Diworsification” is investing in too many assets with similar correlations that will result in an averaging effect. Essentially, if an individual decides to invest in multiple securities and the driving force is to simply diversify, they may end up adding positions that don’t incrementally benefit the overall portfolio. One could make the argument that the VTI is a good example of “diworsification”. Not everybody agrees with having high degrees of diversification. For example, over 100 years ago you could find successful businessman Andrew Carnegie, often suggesting “[c]oncentrate your energies, your thoughts and your capital. The wise man puts all his eggs in one basket and watches the basket”.[5] For most individuals, we wouldn’t agree with Carnegie’s concentration recommendation. However, we do think his thought process is on the right track. Many experts state that only 15 – 30 holdings are needed to achieve the basis of diversification. For example, investor Joel Greenblatt, in his book You can be a Stock Market Genius, states that the nonmarket risk of owning one stock can be reduced via diversification by “…81% with eight stocks, 93% with 16 stocks, 96% with 32 stocks, and 99% with 500 stocks”[6]. Further Greenblatt states that “[o]verall market risk will not be eliminated merely by adding more stocks to your portfolio”[7]. We appreciate you reading thus far, and won’t keep you much longer. So, let’s look into one more element of diversification. Diversification among asset managers, like diversification among the companies within your portfolio, is a true risk that must be mitigated. Again, to what extent? If a person is not convinced in one school of thought pertaining to investing, perhaps multiple managers make sense. Then again, if you have two managers applying opposite frameworks, you could run an additional risk of having those managers average their efforts to a point akin to “diworsification.” Their efforts could negate each other causing their collective client to suffer unproductive results. Typically, we suggest people avoid one manager that is attempting to use several different disciplines as it pertains to investment philosophy. We feel, by trying to gain it all, you actually lose it all. Rather, it may make sense to hire investment managers who are confident and experienced within their respective mindsets. That being said, having only one or two managers still seems like a lot of faith is being placed in a small number of people. That may not actually be the case. For example, at LBW, there is the possibility a client could have as many as 13 portfolio managers. In many of our portfolios, we hold mutual funds that are managed by like-minded managers in conjunction with our own in-house manager, Nathaniel. Meaning, if we utilize 12 mutual funds and Nathaniel manages a piece of the portfolio as well, a client can expect to have at least 13 portfolio managers[8] actively working within their portfolio. Let’s examine this concept from a different angle. Let’s say a person has an account with a Charles Schwab advisor and an account with a Vanguard advisor. They may reasonably think they have added a level of diversification by having two accounts held by different firms. However, what if those two advisors are using the same mutual fund, index fund, or ETF? Or different funds with a high degree of crossover pertaining to companies held within each fund? What if both accounts were passively managed, and designed to simply mirror the movements of the S&P 500? Hasn’t the client unintentionally placed all their “eggs in one basket”? If diversification is not the end-all of mitigating risk, what else should be considered? First, let’s agree that volatility doesn’t equal risk. They may look the same in action, but the end result is vastly different. Second, let’s agree that there is no such thing as risk-free. Understanding what you own in your portfolio is the first step towards mitigating risk. You can further enhance your risk mitigation by applying a margin of safety to your investment purchases in comparison to their underlying values. The human component, those who manage the funds, need thorough consideration. Are those managers putting in the time and labor into the portfolio? Do they have the necessary resources and skill sets to do their jobs? Does their mindset consist of sound judgement and disciplined patience? We at LBW are all for diversification, we just want people to understand what diversification means and apply the appropriate amount. We hope you get two things from this article: 1) it is impossible to diversify any risk, if you don’t understand the risks. Risk disguises itself in many forms – some are clearly visible, some are not. 2) Question conventional financial wisdom. We all have unique life scenarios that require customized consideration and free thought. Things change. Some concepts are misunderstood, and/or may not be relevant to you in the way they are applied. Understanding what diversification means is the first step to figuring out how many baskets of eggs you really want to keep watch over. Sincerely,

LBW

[1] http://www.wordorigins.org/index.php/forums/viewthread/3459/ [2]https://personal.vanguard.com/us/funds/snapshot?FundId=0040&FundIntExt=INT#tab=2 as of 12/31/2016 [3]https://personal.vanguard.com/us/funds/snapshot?FundId=0085&FundIntExt=INT#tab=2 as of 12/31/2016 [4] https://us.spdrs.com/en/product/fund.seam?ticker=DIA as of 1/27/2017 [5] http://www.quotes-clothing.com/wise-man-all-eggs-one-basket-watches-andrew-carnegie/ [6] Greenblatt, Joel. You Can be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits. Fireside, 1999. [7] Greenblatt, Joel. You Can be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits. Fireside, 1999. [8] some of these funds have multiple portfolio managers

#diversification #valueinvesting #indexfund #riskmanagement

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6410 Enterprise Ln., Ste. 120

Madison, WI 53719

(608) 286-1321

tsbickmore@lbw-wealth.com

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