Diversification works?

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Every finance text book extolls the virtues of diversification. Diversification is the holy grail of investing, we are told. Diversification is said to be the only ‘free lunch’ in the world of investing. We are constantly being reminded that we must diversify – to not ‘put all our eggs in one basket’. We need to spread it around, preferably into different sorts of things, into different types of assets, in different industries and in different markets, to give ourselves the best chances of success, and to minimise the chances of loss.

If any one thing doesn’t work out or loses money or fails, then something else is bound to work if we spread it around into enough different things.

We need to have a fall-back plan, a plan B in case plan A doesn’t work, and even a plan C in case plans A and B fail. The more fall-back plans we have the better. Three different asset classes with different characteristics are better than two, and four is even better than three, etc. The more different each one is, the better, so they are not all affected by the same adverse events.

My perfect plan

All this sounds like it makes sense, so years ago I decided to follow the textbooks and diversify in order to give myself the best chance of succeeding in life and making money. Here is my ultimate diversification plan for success:

On Mondays I’m a magician in Mumbai, on Tuesdays I’m a tiler in Tunisia, on Wednesdays I’m a welder in Wellington, then on Thursdays I’m a thoracic surgeon in Thessalonica. But on Fridays I’m a fruiterer in Frankfurt and on Saturdays I’m a sax player in Sacramento. Then I sleep in Sydney on Sundays, before doing it all again the following week.

See? I’m diversifying across different skills, across different markets in different countries and even across different time zones and different regions of the world. It’s the perfect plan!

If the market for magicians in Mumbai melts, I can always turn to tiling in Tunisia. And if that market turns turtle I can always work as a welder in windy Wellington, and so on. Actually the market for thoracic surgeons in Thessalonica is rather thin at the moment, but that’s ok because fortuitously the market for fruiterers in Frankfurt is fantastic right now. Diversification works!

That’s nonsense of course! By diversifying you end up being bad at everything. Nobody ever became good at anything by diversifying.

Nobody ever built a great business, or created a great nation, or amassed a great fortune, or became a great painter or musician or sportsperson or anything else, by diversifying. The only way to become good at anything, or to build wealth, or to build a great company, or become a great doctor or scientist, or to do anything else well in this world is to specialise, concentrate and focus. You need to specialise, concentrate and focus on a single skill, or a single idea or a single business, or a single sport or talent. You need to specialise, concentrate and focus on just one thing and then make that one thing your life’s work.

Warren Buffett, the world’s greatest investor, says: “put all your eggs in one basket, but watch that basket very closely”. Buffett has been following and refining his investment strategy since he bought his first shares at age 11 in 1941. Broadly his strategy is to take big concentrated bets in a small number of companies that he makes it his business to know back-to-front and inside out. He almost always takes controlling stakes or large minority stakes in the companies he invests in, so he can dictate or at least influence their board, strategy and direction, and almost all of his investments have been in the US.

Specialise, concentrate and focus only on what you know best.

No safety nets

Ever noticed how the people who built great companies and made great fortunes often dropped out of high school or college? Even in today’s world when we are told that education is everything? Think Bill Gates (Microsoft), Steve Jobs (Apple), Larry Ellison (Oracle), Mark Zuckerberg (Facebook), Michael Dell (Dell Computers), Ted Turner (CNN), Larry Page & Sergey Brin (Google) and countless others. They didn’t say “I’d better just finish this degree – just in case things don’t work out.” They ditched their fall-back plans and went after their dreams without a safety net, without a fall back plan and without any thought of ‘diversification’.

The best way to go forward is to burn your bridges behind you! To have no plan B or plan C, “just in case”. I’ll bet Mao Zedong never said, “I’ll give this long march thing a couple of weeks and see how it goes, but I can always go back to being a dentist, or tiler”. The same goes for Alexander the Great, Napoleon, John D Rockefeller, or JP Morgan, or anybody else who built a great nation or a great business or a great fortune.

Australia

In the case of Australia, take a look through BRW’s ‘Rich 200’ list in any given year. Almost every single person in the list every year got there by their single-minded focus on their narrow field of expertise, by sticking to it and making it their life’s work. Gina Reinhart, Andrew Forrest and Clive Palmer (iron ore), Harry Triguboff, Bob Ell, Lloyd Williams, Ron Walker, Lang Walker (property development), Frank Lowy, John Gandel and Maurice Atler (shopping centres), Len Buckeridge and the Grollos (construction), Len Ainsworth (poker machines), James Packer (selling his father’s media empire at the top of the market and then focusing instead on casinos), Dick Pratt’s family (packaging), Ivan Glasenberg (commodities trading), Lindsay Fox, Paul Little and Peter Gunn (transport), Solly Lew, Gerry Harvey, John Van Lieshout and Morry Fraid (retailing), Bob Oatley (wine), Bob Ingham (chicken farming), Graham Turner and Geoff Harris (travel agents), are good examples. All are the result of single-minded dedication and focus on their narrow area of speciality, and sticking to it for decades. Sticking to their focus, staying on the narrow path, and never allowing their attention to be diverted into diversions (‘Diversification’ after all is allowing oneself to be diverted into diversions!).

On the other hand there are only a few isolated examples of real success attained in more than one field. One is Kerry Stokes, who made his fortune in shopping centre developments first, and then in media, and more recently in mining services in China (via Caterpillar). Another is Ralph Sarich, who made his first fortune with his orbital engine and then used the proceeds successfully in property development.

Diversification usually spells trouble

For most successful people, diversification gets them into trouble. Their life stories are littered with examples of diverting off the straight and narrow and into areas outside their narrow area of specialty. This is usually in booms when it is hard for even them to avoid getting caught up in the frenzy.

One prime example was Frank Lowy’s failed adventure into television, retailing and oil via Westfield Capital Corp (1986) which collapsed in 1989, losing $300 million. Even within the shopping centre industry, Lowy had several false starts in expanding into the US market – Westfield International (1988-9), Westfield America Trust (1996-2004), and Westfield America Inc (1997-2001). Investors in Lowy’s companies since 1960 have done extraordinarily well, but only if they avoided these ‘non-core’ departures from his single-minded focus on shopping centre development in Australia.

What about ordinary people?

Ok, at this point you may be saying to yourself – “I don’t want to be a billionaire. I just want to make a bit more money.”

This strategy of single minded specialisation, concentration and focus doesn’t just apply to people who ended up being super rich and/or famous. It applies to everybody. Most people play a sport or an instrument or have some type of hobby. Everybody knows that the only way to become even half good at any sport or any instrument or any hobby is to specialise, concentrate and focus on that one sport or instrument or hobby. There are no short cuts. To be half good at anything still takes several years of focus.

This principle applies to people building even modest amounts of wealth. The biggest source of wealth for most moderately wealthy Australians (say $2-5 million) is from their business or profession. Business success comes for specialising, concentrating and focusing on one specific customer need and then sticking to that single narrow focus for many years through thick and thin, through boom times and busts. Professional success also comes from specialisation – whether it is for dentists, architects, lawyers or doctors. In most cases the way to get ahead and build a profitable and valuable practice is to specialise.

Very often, where business people and professionals tend to blow up their money is when they try to diversify into other areas – for example when they venture into other things like a winery, or a property development, or a race horse, or forex trading, or shares in dot-coms, mining explorers, bio-techs or whatever the latest fad is.

I test this principle on people all the time, and readers can ask themselves the same question. When I am talking to investors who have accumulated say $100,000 or $1 million or even $10 million so far in their lives I ask them how they started out with nothing when they were young and ended up with what they have today. In 99% of cases the wealth they have today has come from the fruits of their specialisation, concentration or focus. They built their wealth up to the current level by specialising in what they do best, whether they are a dentist or a boat builder or a plumber.

If I am talking to a lawyer I ask them what they would do if they wanted to make more money – invest some time/money in doing a course to get them into a specialist part of legal practice, or invest time/money in a dentistry course to become a dentist on the week-ends? The answer is simple – you make more money by specialising in what you know best.

So if they have built the wealth they have today from their specialisation and focus, what makes them think they could or should suddenly build the next stage of their wealth by diversifying into a new area (or worse still, a whole bunch of new areas) about which they know very little or nothing. It doesn’t make any sense.

Against human nature

The very idea of expecting better results through diversification goes against the whole history of human advancement and development.

Specialisation, concentration and focusing on specific skills and roles is what got early humans out of caves and into agriculture, and then beyond agriculture into the industrial revolution, and then into the post-industrial information society we live in today. We are all better off today, individually and collectively, because our ancestors specialised, concentrated and focused instead of trying to be good at more than one thing.

The whole modern capitalist system and the standard of living it has generated for us all, is built on the principle of specialisation of each individual, firm and even each country. Each individual, firm and country specialises on what it does best and then trades with other individuals, firms and countries for everything else. For example, we live longer and healthier lives today because our forefathers (and foremothers) specialised, concentrated and focused on what developed into what we know today as the medical profession. Without specialisation, concentration and focus in all areas of human endeavour we would still be grunting to each other in the back of caves and living very short brutish lives.

So, if the key to success with building wealth, or building anything else of value to ourselves, our families or society is through specialisation, concentration and focusing on doing just one thing well, surely diversification is a backward step?

Why are we constantly being told that diversification is the key to building wealth?

In future articles I will explore what role diversification plays in investing – where it works and where it doesn’t. But for now I gotta go. Tomorrow is Monday, so it’s off to the Mumbai magic market for me!

Ashley Owen is Joint Chief Executive Officer of Philo Capital Advisers

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13 Responses to Diversification works?

  1. Ross November 5, 2013 at 9:31 PM #

    We need first to examine what diversification is. Classically, in a public-oriented forum, diversification is a technique in capital whereby risk is split between multiple different asset classes. I think the problem here is that your article is about diversifying in a business or educational manner. Obviously that has its downfalls. However, diversification within the financial market is ‘the only free lunch’, it allows you to increase return potential without increasing risk. So, if you were to say that diversification in financial markets is useless, you would be wrong. I recommend that you clarify your article by adding a sufficient title or introduction so that the reader is clear that you are writing about diversification by companies or in education.
    Regards,
    Ross.

  2. Marc C August 22, 2013 at 8:16 AM #

    Possibly the answer is to specialise in diversification?

    Perhaps defining diversification may be worthwhile?

    There are good and bad times to invest in assets (or classes thereof), diversification is pointless if it includes investing in assets that are too expensive and vice versa I believe.

  3. ashley August 21, 2013 at 3:37 PM #

    HI Aaron,
    Precisely. Building a fortune from scratch when you are young when you have no dependents and plenty of time to make mistakes and start again is one thing, but then turning that wealth into reliable regular inflation protected cash flow withdrawals when you are unable to work any more is entirely different.
    The problem is that most pre-retirees and retirees I talk to say they want to “build wealth” when what they really need to do is protect their existing wealth and turn it into regular cashflows for themselves and their dependents for perhaps decades in retirement.
    It is all about setting realistic expecations, goals, and understanding cash flow needs, time horizons, willingness and ability to take risk, etc, which does require diversification and careful risk management. That is in Part 2 of the story. Part 1 was all about challenging the notion that retirees think their goal is to “build wealth” and “invest like Buffett”, etc.
    cheers
    ashley

  4. Aaron August 20, 2013 at 11:46 AM #

    A thought provoking article Ashley. I think it could be extended by considering the skills/ knowledge aspect that you raise. If you have skill or knowledge in a particular area, then that reduces the need for diversification, presumably because you have a greater chance of recognising any risk in advance
    Most people accumulate their wealth using skills other than the investment management of companies or bonds, Buffett an obvious example. Lacking these specialist skills, but wanting to earn more than a risk-free government bond rate, most investors should diversify their investments. Any investment outside a self-owned business is the start of diversification.

    I would also add that there are many more people who drop out of school that end up going no-where than there are those who become multi-billionaires. Sure, the mega-rich have generally got there because of one thing they did, but is that really a sensible target of someone looking to invest their hard-earned savings?

  5. Michael C August 19, 2013 at 10:08 PM #

    I guess it comes down to how many eggs are in the basket. About half a dozen eggs would spread risk and knowledge.

  6. ashley August 19, 2013 at 11:57 AM #

    Hi Simon, I’m glad you raised this.
    Twain was indeed the source of the original quote. It has also been used many times since, by Andrew Carnegie in 1885 and several others. Even Ben Graham observed, “The really big fortunes in from common stocks have been made by people who packed all their money into one investment they knew supremely well.” (“The Intelligent Investor”).

    Buffett rarely interviewed or wrote, but many books about him have been written (I have studied many but not all), and there is a wealth of evidence that he favoured extreme concentration over diversification. He used various versions of the eggs metaphor including the Mark Twain version. Buffett often said that spreading your eggs across several baskets increases risk (see Hagstrom, “The Warren Buffett Way”, p.47).

    One extreme example was in 1992 when Buffet said that if you were “going away for 10 years and you wanted to make one investment” and “you couldn’t change it while you’re gone”, then you could be confident owning just one stock – Coca-Cola (quoted in Kilpatrick “Warren Buffett: The Good Guy of Wall Street”, 1992, p.123).
    That’s one egg in one basket (at that time Coke was 40% of Berkshire’s portfolio).

    The source of Buffett’s use of the eggs in one basket metaphor was probably Buffett’s close mentor Philip Fisher, who used it repeatedly. Buffett did start out in the early years applying the principles of his professor Ben Graham and other Graham disciples like Walter Schloss, focusing on diversifying across many companies bought below their intrinsic value with little regard for management or understanding each business. But Buffett very quickly switched to focus on a very concentrated portfolio of just a few great businesses he studied and understood inside out and intended to hold forever.

    The transition from Graham-style diversification to extreme concentration probably came in the late 1960s or early 1970s, marked by the purchases of GEICO (1972) and Washington Post (1973), and most certainly by the late 1970s – with GEICO (1976) and Capital Cities (from 1977).
    We can see this complete shift expressed in the 1991 Berkshire Annual Report p. 15, with Buffett quoting Keynes’ view that there are “seldom more than two or three enterprises” worth investing in.

    The main influences of this shift to concentration were probably Philip Fisher (the eggs in one basket metaphor, and better to own a few excellent businesses you know very well), Bernard Baruch (one cannot possible truly understand more than a small number of businesses), and Keynes (investment success comes from a very small number of great investments).
    A major contributor to the shift from Graham-style diversification to extreme concentration was probably Charlie Munger, who often used the eggs in one basket metaphor and ran a far more concentrated portfolio than Buffett. Munger met Buffett in 1960 and joined Berkshire in 1978.
    It is said that Buffett often boiled it down to aiming to make just 10 investment decisions over your entire lifetime (see M. Buffett “Buffettology”, p.174). (Or 20 decisions, including sells, in a whole lifetime – Buffett quoted in Forbes 25 May 1992, p298). That really does focus the mind on concentrating one’s efforts on just a few big decisions, not diversifying across many.

    But Part 1 of my story was not intended as a study on Buffett. The fact remains that very few people made their fortune by diversifying. Even the father of diversified index investing, John Bogle, made his fortune by building and one great business – Vanguard.

    Making a fortune almost always comes from narrow specialisation and concentration, not diversification. However having made one’s fortune, turning it into reliable, regular cash flows for retirement is the opposite. That is a very different investment goal, and it is the other part of the story.
    Cheers
    Ashley

  7. Warren Bird August 19, 2013 at 11:36 AM #

    Yes, Twain used it in one of his novels, so I’m not sure whether it was Mr Clemens’ personal view or that of some fictional character. However, Andrew Carnegie is more likely to have come up with the saying about ‘watch that basket’, with Twain using it in his writings. I understand that the full quote is:

    “The way to become rich is to put all your eggs in one basket and then watch that basket.”

    They are talking about doing your job, running your business, etc well. Trying to hold down 25 jobs all doing different things is not a good idea! They are not talking about investing the savings you are able to generate from the one basket that your labour can be put in. Once it comes to investing, the only way to manage the risk of losing it all is to diversify appropriately.

  8. Simon Payne August 18, 2013 at 1:35 PM #

    I think if you are going to quote Buffett you should do so correctly. The actual quote is from Mark Twain. What Buffett said was in relation to having the majority of his personal wealth in Berkshire Hathaway.

    He said, “Charlie and I feel totally comfortable with this eggs-in-one basket situation because Berkshire itself owns a wide variety of truly extraordinary businesses. Indeed, we believe that Berkshire is close to being unique in the quality and diversity of the businesses in which it owns either a controlling interest or a minority interest of significance”.

    In other words, the opposite of this author’s point.

  9. Warren Bird August 16, 2013 at 4:53 PM #

    2008 was actually a proving ground for diversification, especially in the asset class where it’s most important. Many bond or income funds that were concentrated in their corporate or structured bond risks have experienced significant irrecoverable losses. However, corporate bond funds that were well diversified – small exposures across a range of companies, industries and countries – have performed strongly. Yes, they experienced mark to market valuation impacts, but they didn’t have defaults and have been able to ratchet up their interest earnings since then in a higher yielding environment.
    In corporate bonds, there is no ultimate price upside. You either earn your interest and get repaid, or you lose money from defaults. So you have to minimise the impact of defaults on your returns. Funds that did this are still around, delivering for investors. Funds that didn’t are either still sitting on unit prices way below 1 or are locked up trying to recover what they can for investors.
    Just one comment from me on Ashley’s article, in relation to his comment that some successful business people have done badly by ‘diversifying’. I don’t regard going from one activity focus to having 2 or 3 as diversification. It is still a highly concentrated position to be in. And in the context of someone using their labour and intelligence day in, day out, if you move into something you aren’t familiar with it can bring you unstuck. But no more, really, than sticking with the one thing. EG look at Blackberry right now – they are sticking to what they know and getting creamed by Samsung, etc just doing it better.
    This is really an argument for doing well, knowing your market, growing and developing. I’m sure there are lots of examples of successful business people who added a new string to their bow and did well out of it. These outcomes have nothing to say about diversification because they aren’t diversified!

  10. Grant Patterson August 16, 2013 at 4:37 PM #

    Perhaps our specialisation could be diversification and then everyone would be happy.

    My expereince is that concentration of investment funds makes a big impact to ones wealth (one way or the other) whereas proper diversification protects one’s wealth.

    Too much diversification equals index at best.

    Focus on valuations, deviation from mean and human behaviour for successful wealth accumulation and preservation.

    Simple but true.

  11. Paul Umbrazunas August 16, 2013 at 3:16 PM #

    The key flaw of this analysis (of which there are a few) is that we generate and create wealth (i) via the services we provide as individual labour and subsequent “re-investment” leading to greater productivity, be that in our own labour or direct investment associated with our labour and (ii) the accumulation of completely extraneous assets/investments.

    These two “methods” of wealth creation are exclusive and so various (granted- albeit debatable) maxims around optimising can’t simply be switched. The arguments around specialisation of labour thus can’t directly be transposed to those around asset allocation.

    Whilst I agree 2008 showed diversification is not a “free lunch”, it’s still cheap.

    It is also largely used in terms of risk mitigation as opposed to wealth generation. Thus, protecting what you have accumulated so that when the (inevitable) {“X” – pick your number here 4-14} standard deviation event occurs, your “new” and unhappily lower starting point will be higher than that of a “specialist” unless that specialist happened to be in exactly the right class of asset (cash) at that exact point in time.

    Nonetheless, given the responses, a thought provoker.

  12. Ramani August 16, 2013 at 11:48 AM #

    Not being a fundamentalist devotee at the altar of diversification, I find Ashley’s article riddled with logical fallacies. His choice of multiple roles across the world is amusing, but unrealistically irrational. If someone with particular skills also learnt unrelated capabilities, this does cater for changing markets. Also, people’s fear of loss and elation at profits are asymmetrical, as behavioural finance tells us. ‘Sleep easy’ factor, really.

    If only we can, with reasonable certitude, predict how different assets would behave over the investor’s actuarial life span, I agree specialisation is the panacea. Those not endowed with hindsight acuity (blame ophthalmology for lack of innovation!), namely all of us, have to spread things a bit to sleep easy.

    Congrats, nevertheless: like anyone jolting a somnolent audience, you have used provocation to make us think that diversification is not all that it is cracked out to be. I wonder why you left out operational risk which is not all helped by it.

  13. Pat Connelan August 16, 2013 at 11:24 AM #

    What nonsense. I seem to recall in 2000, spruikers like this guy telling mug punters to fill their portfolios with tech stocks. In 2006-6, it was all about high conviction, high yield structured notes. In 2009, it was fill your boots wiith resource stocks. And on and on it goes.

    Unless you’re a venture capitalist with a ton of cash to burn, you have no business taking big concentrated bets. Diversification remains the only free lunch.

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