Why Investment Diversification Wins in Your Portfolio

The opposite investment strategy of specialization is diversification. I previously discussed why you should specialize in your business or professional career. Most high-income professionals are intimately familiar with that idea after years of honing their craft. In that context, the hard work usually pays off. Unfortunately, we often then extrapolate that approach to our investment portfolios. That attempt to specialize and outperform at investing in financial markets leads to a wider range of results. Counterintuitively, the most likely outcome is underperformance due to several factors.

Learn why and how to mitigate uncompensated risk by understanding investment diversification. You must understand it deeply enough to combat your natural tendencies and the people selling you their “winning strategies”.

Win At Investing By Not Losing

To win at investing, we must buy something lower and sell it higher. That profit must also outpace inflation and be net of fees and taxes for us to have more buying power in the end. Over 90% of funds that do try to outperform trail the relevant index.

The magnitude of lagging performance is not trivial either. It may average ~2%/yr (close to fee drag) and is worse with higher manager conviction. Another mathematical analytical approach estimated the risk-adjusted cost of market timing of 1.25%/yr and stock picking with 20 stocks at 0.8%/yr. It is interesting how different approaches and data sets have yielded consistent results. These decreased returns align with the peeks that I’ve had into my family, friends, and colleagues’ portfolios too.

The alternative approach to attempting to outperform the market is to win by not losing. That translates into beating >90% of “the competition” by a significant margin. You can avoid losing to fees by using effective low-cost products, like broad passive ETFs. Minimize the loss to taxes by using your tax-sheltered accounts, like RRSPs, TFSAs, FHSAs, and RESPs.

You can also avoid losing money by mitigating uncompensated risks. This is the strategy of diversification.

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Take Compensated Risks

Investing money means that you have a reasonable expectation of making a profit. When you invest using stocks, bonds, or funds that hold them, you are buying the future expected cash flow of the underlying assets. Investors logically discount those future cash flows to come up with a current price.

When many investors come to the table with their expectations about the future and price, that is a market. So, an efficient market processes all of the known information about the probable future outcomes and produces the market price. Large liquid markets, like the stock and bond markets, are not perfectly efficient. However, they are efficient enough that you likely lose trying to beat them or your competitors due to cost and lack of efficacy.

Those discounts built into prices reflect the fact that those future profits are not certain. They are risky. The higher the risk, the higher the discount would be. That is why risk and expected return are related. If the future does unfold as expected, you get compensated for taking the risk. The risk to future cash flow is intrinsic to the investment. You cannot diversify it away. However, it is a “priced risk”, and in the aggregate, you can reasonably expect to get paid for taking it.

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Beware & Mitigate Uncompensated Risks.

Several risks are not “priced in”. So, you don’t get compensated for taking them. No one wants to work or take risks without getting paid! Unfortunately, they are unavoidable. However, you can mitigate them as much as possible.

The first step to that is to be aware of them. The big uncompensated investing risks are behavioral risk, specific risk, and systemic risk. You can mitigate behavioral risk by choosing a suitable asset allocation, avoiding exposure to expensive story-tellers, and developing an easy-to-stick-to plan. Part of that plan should be to mitigate the unpriced risk through investment diversification. Systemic risk is hard to dodge and the details are unknown, but you can plan for it by building financial resilience.

Diversify to Reduce Behavioral Risk

The biggest risk to your investing success is you. You are human and subject to the emotionally driven behavior that goes along with that. Humans are wired to want things when they are popular (and more expensive) and shun them when they are not (and cheaper). That is driven by fear and greed.

We also have biases, like recency bias. Further, we are social beings and those biases and emotions are influenced by those around us. This risk of buying and selling at bad times is called behavioral risk. You don’t get paid for being human. However, you can set yourself up for success by acknowledging and mitigating it. Diversification of your investments helps.

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Bad Behavior Costs Money

I am not talking about fines and legal fees following your trip to Vegas. I am talking about doing worse than if you just invested your money robotically and tracked the comparable market index. It is no joke. The behavioral gap, as detailed in Morningstar’s Mind The Gap Report, can range from 1.5-1.7%/yr depending on the rolling 10-yr period looked at. That means investors trail the funds that they invest in by 1.5-1.7%/yr. It is not all due to buying and selling funds at bad times, but that is the main contributor to underperformance. Another model of the impacts of behavior showed investors trail by ~1.5%/yr.

It is also important to understand that 1.5%/yr is the average. The gap can range from almost zero up to over 7%/yr. One of the main correlates of that is volatility. Larger price swings (volatility) stoke our emotions more and are like poking our emotional inner hulk-investor in the eyeball. Diversification helps to dampen that volatility.

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Investment Diversification, Volatility, & Expensive Misbehavior

When you look at the different asset classes, the less diversified ones have a larger behavioral gap. For example, the prize for worst behavior goes to narrowly focused sector equity funds. Investors in those funds trailed the funds themselves by 4.38%/yr. In contrast, broader equity funds had a behavioral gap of 0.8-1.6%/yr. The broad funds are diversified and less volatile.

Controlling for the fund type, you can also see the effects of volatility. For example, within the sector equity fund group, investors in the most volatile funds trailed by an average of 7.47%. In contrast, investors in the least volatile sector funds trailed by ~3%/yr. That is still 3%/yr!!

Due to their inherent risks, you would expect bonds to generally be less volatile than equities. So, you may expect that those “safer” bonds had the lowest behavioral gap. But, they did not. The lowest behavioral gap amongst investors in different fund types was found in asset allocation funds. A measly 0.46%/yr!

Those asset allocation funds hold a mix of stocks and bonds. Not only is that diversification amongst assets, but across two poorly correlated asset classes. The less correlated the investments are, the more effectively diversification dampens volatility. Some go up while others go down, but the average is up over time.

Investment Diversification Against Specific Risk

Another uncompensated risk that you can mitigate is “specific risk”. Idiosyncratic unpredictable events do happen. They could be specific to a company, like accounting anomalies (fraud), management mistakes, or changes to the competitive landscape, or even unfortunate Tweets. Unforeseen disruption can happen to whole industries. Artificial intelligence is the latest candidate disruptor.

Government regulations can change, impacting broad industries like real estate (eg. short-term rentals), banks (eg. recent windfall tax), or oil and gas (climate change policies). On the flip-side companies across different industries in a specific region can experience idiosyncratic disasters. Like natural disasters or human conflicts.

You don’t have to look very hard to find examples. The unexpected happens frequently.

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Investment Diversification Helps

You cannot eliminate these risks to investing. However, diversification amongst multiple businesses, across different industries, and spanning the globe mitigates it. That is why “specific risk” is sometimes called “diversifiable risk”.

On a business level, this is pretty easy to see. For a recent example, look at what happened to Silicon Valley Bank. It was struggling due to some bad decisions, but it collapsed when social media exacerbated a bank run on its holdings. I wanted to show you their stock price chart, but they went bankrupt and were delisted. However, I can show the US regional bank chart though. The industry chart is better than a total loss but still shows a nasty decline. Diversification to the entire US market decreases the impact when that type of idiosyncratic uncompensated risk manifests. The US market dominates the world, but geopolitical-specific risk is reduced by further global diversification. You can see this, as well as the time to recovery below.

Be Prepared for Systemic Risk

Some uncompensated risks are hard to mitigate. They affect pretty much everything. These are called systemic risks. That is not to be confused with systematic risk, like the day-to-day pricing of assets based on uncertain future cash flows. A systemic risk usually manifests from a major exogenous shock. Like the Covid pandemic, the global financial crisis of 2008, or the impending Rise of the Machines due to artificial intelligence. It is pretty hard to diversify against that type of risk. I think that the best that you can do is plan for it.

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Planning for the Bogey Man

With investing, pessimism is very expensive. There have been many external systemic shocks: World Wars, financial crises, energy crises, major pandemics, and not enough Taylor Swift tickets. Markets may gyrate, but humans adapt and find a way forward. You mainly need to plan for that and be able to ride it out. That is why I advocate for building a solid financial platform before investing.

To build financial stability, make hay while the sun is shining at your job. Spend deliberately, but don’t spend it all. Earning and spending effectively are essential financial skills that you must master. Be aware of your fixed and discretionary expenses and consider them carefully before taking on major fixed costs. Deal with debt effectively. Build up some savings to take care of expected expenses and some buffer.

Diversification applies to your life, beyond your investments. Remember to also build your social and human capital. When bad-shit-happens, you will need allies and support networks. On a related note, as I learned during the pandemic, always keep a Costco-sized package of toilet paper on hand. In a crisis, it is the real gold or bitcoin if the world goes Mad Max.

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Gold To Diversify Against Systemic Risk?

Gold has been touted as a hedge against systemic collapse. Historically, gold has a low correlation to the stock market. However, it also has been a pretty big drag on performance except during unpredictable brief self-limited periods.

Gold as a financial asset does not produce income. It is a commodity. So, its value is largely tied to what people are willing to pay for it. If it is a financial crisis, then it might hold value as a currency. Note that gold did not spike in value during the two World Wars. It trailed the stock markets during the recent COVID crisis and did not significantly outperform during the subsequent inflationary recovery period either.

The other problem with gold is storage and trade. If there were truly a systemic collapse, do you think your shares of a gold ETF would be honored? If you have physical gold instead, can you keep it safe? How would you trade it for goods in practical terms? You had best have guns and ammo too. I don’t think an electronic currency in a post-apocalyptic world will fare much better. Who will be tending to the internet and power grid?

Maximize Compensation. Mitigate Risk.

We have seen the fact that specialization as an active investment manager usually underperforms. However, it is important to understand the underlying reasons for that and why diversification instead of specialization is the answer. You will be challenged on this by your intuition and prodded by those selling active strategies and products. In fact, your intuition and feelings usually work against you. You don’t get compensated for bad behavior. Instead, diversify amongst asset classes, like stocks and bonds, to dampen the volatility that pokes your emotional inner investor beast’s eyeballs.

Investment diversification maximizes the chance of you being compensated for taking risks without getting derailed by taking uncompensated risks. For example, you can benefit from the overall fact that equities have risk priced into them. You get a discount now based on the risky future and can expect compensation for taking it. However, individual stock results are highly skewed towards loss.

Only 4% of stocks account for the market returns over 90 years of market history. The most common individual stock outcome is total loss. So, your best chance is to make sure that you own those 4% before they come out on top. Diversification to own the whole market does that. “The Market” can mean many things. Diversify across industry sectors and geopolitical regions. That mitigates as much of the specific risk as you can.

You cannot mitigate all idiosyncratic risks. Systemic risk from external shocks with broad impacts occurs regularly, but unpredictably. Your best chance to mitigate against those systemic crises is to have a strong financial platform. Before you invest in riskier assets. Plus, have a toilet paper stockpile. Then, invest your excess money regularly in a diversified portfolio.