ANTONIO Believe me, no: I thank my fortune for it,
My ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year:
Therefore, my merchandise makes me not sad.
SALARINO Why, then you are in love.
–Act I, Scene I Venice. A street, The Merchant of Venice
There are some surprisingly, ah, diverse ideas in finance about what diversification is and is not and why it is or is not a good idea. Common wisdom from Ecclesiastes to Shakespeare says simply not to put all your eggs in one basket. The diversity of opinion seems to hover around how many eggs and what kind of baskets.
Over the next three days, I post three short notes, the first two on what is not diversification, and the last on the most effective way to put diversification to work in an Upside portfolio.
Multiplying Risk with Multiple Funds
Here is the first of two simple examples of what diversification is not:
1). Diversifying investment strategies is not diversification.
Mutual funds are essentially pre-packaged investment strategies. You pay an annual fee—sometimes preposterously high—for a share of the results from the strategy the fund manager runs in the fund (the fund’s bet). So maybe owning ten or twenty really interesting high-powered (“well-advertised”) mutual funds with promising strategies or past records of beating the market improves the odds of winning the bet. On the surface, investing in a “diverse” selection of funds and strategies seems like a smart thing.
Here’s the problem without putting too fine a point on it. Anywhere from 60%-70% of mutual funds fail to produce average returns each year depending on the type of fund.* That means mutual funds lag market returns accordingly, since the average fund’s return (median) is lower than the whole market’s return (mean).
So then holding many of them will improve my odds, right?
Not exactly—if one fund has a 40% chance of beating the average, then two funds have only a 16% chance (40% x 40% = 16%). And twenty funds? 0.0000011%. There is essentially no chance that twenty funds will produce anywhere near market returns. Each of the twenty funds has the same 40% chance of beating the market—which is less than random luck (50/50). The chances of picking twenty that will somehow cumulatively beat the average is infinitesimally tiny. You might as well buy twenty lottery tickets.
Sure, the top twenty funds each year out of the thousands available beat the average, but sadly, it’s a different twenty every year, all but a certainty not the twenty you own, and there’s no way of knowing which twenty it will be this year or next. Only hindsight shows that.
That bears repeating—there’s no way to know. No one knows the future and which strategy will win or lose. Last year’s winners, statistically, do worse than average in subsequent years. Some, of course, continue to do well. But over five years, less than 1% of the top quartile performers remain in the top quartile.*
If you hold a bunch of funds, do not be blinded by the one winner that never seems to let you down. One winner out of six or ten or twenty sub-performers is not market beating portfolio performance. This is true whether the funds are held in a 401(k), and IRA, or a brokerage account.
Holding lots of mutual funds is not diversification. It’s counter-productive. You can do better.
The remedy is not to toss out the losers and put your money in new “better” mutual funds—new guesses about “winners.” That’s a long-term strategy for underperforming the market. Tomorrow we’ll look at a second not-diversification—Individual Stocks, Is That a Good Idea?
*No less an authority than the people who bring you the S&P500 offer this analysis: https://us.spindices.com/resource-center/thought-leadership/spiva/
S&P Indices Versus Active (SPIVA®) measures the performance of actively managed funds against their relevant S&P index benchmarks.
- The SPIVA® U.S. Mid-Year 2014 Scorecard: “The past five years have been marked by the rare combination of a remarkable rebound in domestic equity markets and a low-volatility equity environment. This combination has proven to be difficult for domestic equity managers, as over 70% of them across all capitalization and style categories failed to deliver returns higher than their respective benchmarks.”
- The Persistence Scorecard: December 2014: “An inverse relationship exists between the measurement time horizon and the ability of top-performing funds to maintain their status. It is worth noting that less than 1% of large- and mid-cap funds managed to remain in the top quartile at the end of the five-year measurement period. This figure paints a negative picture regarding the lack of long-term persistence in mutual fund returns.”